Credit default swap ban leaves EUR vulnerable
With volatility in the FX market hitting its lowest level since before the start of the financial crisis, many are looking for the trigger that will push currencies out of the tight ranges that have held in recent months.
The stasis is all the more remarkable given the substantial challenges faced by the world economy and the continued concerns about eurozone debt, not to mention the not so small matter of a US presidential election.
Some are looking for the US poll on November 6 to put some life back into the market, while others point to pending legislation in Europe as a potential trigger.
On November 1, the EU’s ban on speculative positions in credit default swaps (CDS) comes into effect, which threatens the increased use of the unregulated currency market as a proxy to bet on the future of the eurozone.
EU politicians argue that naked CDS positioning has been one of the factors that has aggravated the eurozone debt crisis, and therefore reason that if investors are stopped from speculating on CDS prices, the problems will ease.
“They might be right,” says Steve Barrow, head of FX strategy at Standard Bank. “But equally, traders and investors who want to bet against EMU might just transfer their activity to another market that’s not subject to any restrictions – such as the euro.”
The CDS ban is not total. Market makers are exempt, as are positions opened before March this year, while if investors can prove CDS positions are a hedge, they will be allowed.
Still, the EU has been putting its plans together for more than a year, during which time CDS trading volumes have slumped.
That trend should continue, making CDS indices meaningless as tools for tracking EURUSD.
Barrow says this is a shame, given how movements in the CDS spread between the US and eurozone have helped explain movements in EURUSD in recent years.
“If sovereign CDS prices no longer reflect the market’s true feelings about countries default risk, then these sorts of spreads will no longer help our forecasting of EURUSD,” says Barrow.
More importantly, the volatility lost in the CDS market is likely to transfer to the currency market.
With the CDS market out of bounds, and with short-selling restrictions on other assets, such as stocks and bonds, in place, the euro will stand alone as the place where investors can take a position if they suspect a substantial rise in default risk in, for example, Greece or Spain.
Of course, that does not mean the euro will tumble. Policymakers might be seen to be getting to grips with the crisis, and the single currency could continue to rally.
However, it will be a different story if the eurozone crisis resurfaces.
As Barrow puts it: “If policymakers have got it wrong and the region continues to struggle, the reduction in the number of viable ways to express bearish positions could make the euro more vulnerable than it has been.”
We have seen what happens before when investors start using the liquidity of the FX market as a proxy when other markets shut down. Just ask anyone who was short yen when Lehmans collapsed.