The IMF has released a damning report criticizing the European ban on purchases of naked sovereign CDS (SCDS). It not only questions the fundamental premise that CDS trading contributes to market volatility but asserts that even if it does there are more effective ways to mitigate this. Whether SCDS markets propagate contagion is difficult to assess since the risks embedded in SCDS cannot be readily isolated from those in the financial system, the report concludes. However, SCDS markets do not appear to be more prone to high volatility than other financial markets. While there are some signs that SCDS overshoot their predicted value for vulnerable European countries during periods of stress, there is little evidence overall that such excessive increases in countries SCDS spreads cause higher sovereign funding costs.
The IMF goes on to emphatically state that the naked CDS ban in Europe is a policy mistake.
Overall, the evidence here does not support the need to ban purchases of naked SCDS protection. Such bans may reduce SCDS market liquidity to the point where these instruments are less effective as hedges and less useful as indicators of market-implied credit risk. In fact, in the wake of the European ban, SCDS market liquidity already seems to be tailing off, although the effects of the ban are hard to distinguish from the influence of other events that have reduced perceived sovereign credit risk. In any case, concerns about spillovers and contagion effects from SCDS markets could be more effectively dealt with by mitigating any detrimental outcomes from the underlying interlinkages and opaque information. Hence, efforts to lower risks in the over- the-counter derivatives market, such as mandating better disclosure, encouraging central clearing, and requiring the posting of appropriate collateral, would likely alleviate most SCDS concerns.
The banning of naked CDS in Europe will have unintended consequences. Liquidity will fall and volatility will increase. This has big implications for long-term borrowers in the eurozone and their ability to attract capital.
- Paul Crean, co-founder and CIO of Finisterre Capital