Short-selling bans on credit default swaps are as yet untested in their effectiveness. All academic studies conducted so far have failed to find a causal link between CDS activity and a rise in government bond yields, and the second-round effects of contagion risk.
Germanys ban on naked shorting of CDS in May, based on the accusation that it was driving up yields on Greek government debt, proved to be controversial on two fronts: because it wasnt coordinated across Europe, and because the level of open short positions was a mere fraction of the bonds outstanding.
In the light of this, research published by Fitch Solutions, a division within the rating agency that analyses the role of liquidity on markets behaviour, may have important policy implications as the European Union seeks to impose reform on the derivatives markets over the coming year. Fitchs research found that the level of liquidity on sovereign CDS was highly correlated with the level of the underlying bond yields.
In instances where liquidity in sovereign CDS was low, yields on the bonds that they referenced tended to rise, and vice-versa. Liquid CDS markets provide investors with the ability to hedge higher-risk debt, thus playing an important factor in driving demand for the underlying cash instruments.
So in the case of Europes peripheral sovereigns, such as Greece, Ireland, Spain and Portugal, an efficiently functioning derivatives market is crucial.
Greece extra yield and liquidity premium
"Liquid CDS markets provide a significant benefit to sovereign entities, in particular for heavily indebted nations with large deficits to fund," the report says. "This is even more important during stressful events."
Still, the head of Fitch Solutions, Thomas Aubrey, is quick to add that its analysis does not imply that any market intervention that might reduce liquidity during times of stress would widen bond yields further, thus exacerbating sovereign funding issues. Indeed, the report states that proposed regulations tabled by the EUs internal markets commissioner, Michel Barnier, in September were a step in the right direction in encouraging greater liquidity in sovereign debt derivatives contracts. By introducing measures to standardize contracts and implementing a central counterparty clearing mechanism the regulations will lower the risks of trading and increase liquidity.
As part of its reforms and in response to Germanys unilateral action to ban short-selling of sovereign CDS, the EU proposals stipulate that any counterparty with a short position in sovereign debt or credit default swap contracts would have to notify the relevant competent authority whenever any such position reaches, or falls below, a relevant notification threshold, as yet to be determined. This would take into account, among other things, the total value of outstanding issued sovereign debt for each member state and the EU and the average size of positions held by market participants holding such debt.
Counterparties would also have to prove that they have made arrangements to borrow the underlying debt instrument. Trading of sovereign debt derivatives has been growing 30% on average in recent years, and will only become more common as European peripheral countries seek to fund their growing deficits and some to restructure their debt. Creating an efficient market for investors to hedge their risks will mean striking the right balance between allowing all market participants to be involved, both long and short.
"Sovereign issues are likely to be with us for most of the next decade until we see a combination of further unparalleled interventions, big currency moves, inflation, restructurings and/or defaults," Jim Reid, head of fundamental strategy at Deutsche Bank in London, writes in a note to investors. "We are not close to any of these at the moment but over time well likely see these themes re-emerge. History would have to be rewritten if we dont."