Credit Default Swaps’ Naked Truth Trail

The IMF’s April Global Financial Stability Report in the wake of capital controls endorsed for Cyprus’ “exceptional circumstances” directly challenged the preceding ban on uncovered “naked” sovereign CDS which has since shrunk the $3 trillion notional market. The absence of an underlying government debt position does not fuel speculation more than other fixed-income and derivative instruments and the connection between shorting and higher funding costs is unsupported by the research as a “negative perception.” As they rapidly reflect information overshoot can occur especially in crisis periods, but useful hedging and liquidity capacity is lost with outright prohibition instead of addressing imperfections with greater disclosure and central clearing mandates. Banks and corporations dominate the $30 trillion gross CDS space and in the top 10 sovereigns France, Germany, Italy and Spain have joined emerging economy stalwarts Brazil, Mexico, Russia and Turkey according to NY-based Depository Trust data. Under the EU’s November 2012 rule protection can be bought for 30 countries only if exposure can be “meaningfully” correlated under dealer status. The vague criterion for eligibility has led to participant withdrawal and stress reduction with the ECB’s bond-support program has diminished demand. The European Securities Authority will review the 6-month impact of the directive over the summer and may recommend clarifications and modifications as global alignment evolves on margin and netting procedures. On the other hand parliament members who will debate the findings have also called for outlawing sovereign CDS altogether, which will particularly hurt shallower developing capital markets with fewer short-selling options. The trade association EMTA has already noted a sharp quarterly volume drop outside the region since the European move went into effect and the Greek triggering raised new questions about default definitions and settlement pricing. For that universe spreads have declined post-crisis but commercial and regulatory doubts have deterred investors from reflecting a positive view. The study urges more aggregate data on the field for prudential supervision but sees “no evidence” it is a worse threat than normal bond engagement.

The US Treasury’s latest international exchange rate report in the same vein casts doubt on such “unconventional” policies in view of Cyprus’ forced depositor losses and withdrawal limits. It comments that money market normalization was aided by the ECB’s bond-buying and long-term refinancing operations, with one-quarter of the latter’s 3-year over $900 billion facility recently repaid mainly by healthier banks in the core Eurozone. The 2014 plan for a single supervisor and resolution regime further “eased pressure” but reversals may now loom with the island rescue’s capital flow implications, which has already raised secondary market debt spreads. Bank shares have fallen amid shorting restrictions there too by individual members. With Portugal due to return to commercial borrowing in September as the constitutional court annulled previous austerity moves the government survived another no-confidence vote as the Treasury cited  higher periphery “uncertainty” with the obvious obstacles.