* Short selling ban hurting CDS liquidity
* Investors to seek other means of protection, positioning
* Corporate, government bonds seen as possible alternatives
LONDON, Nov 1 (Reuters) - New rules to stop speculators making Europe's debt crisis worse by betting on government bond defaults are prompting investors to find alternative ways to insure against or profit from bad news in the region.
Credit default swaps (CDS) on sovereign bonds, a derivatives product offering insurance against a government failing to honour its debt, became very popular at the start of the euro zone debt crisis. While some investors used them to protect their holdings of debt, others have bought them to make a killing when the crisis deepens, which can further weaken market sentiment and push up the cost of borrowing for governments.
That has unsettled authorities and, from Nov. 1, European Union rules outlaw the speculative bets, saying investors can only buy a sovereign CDS as insurance against a bond they own.
In anticipation of the rules - aimed at increasing transparency and stamping out market manipulation - investors have pulled out of the $100 billion market in droves, with volumes already down about 40 percent from mid-2011 peaks.
Instead, they are tentatively switching to buying corporate CDS, selling sovereign bonds or using the options market.
``If you've restricted them from using sovereign CDS ... they will clearly look for some alternative that is out there,'' said Saul Doctor, credit strategist at JPMorgan.
``The most obvious alternative is just to go and short the bonds outright or going short through the futures market.''
Short bets on bonds - when investors sell bonds they have borrowed, betting the price will fall so they can buy them back and repay the loan at a profit - also need to be covered. In other words, an investor cannot make an arrangement to sell bonds they have not yet agreed to borrow, since this runs the risk of wildly speculative movements divorced from the fundamentals of the underlying asset.
Covering short bets can be done relatively easily in the repo market, where bonds are used as collateral to borrow cash, but it is more expensive and requires more disclosure than the CDS market.
The value of German sovereign bonds on loan - an indication of shortselling levels - has risen 6 percent in the past two months, while for Italy the rise is 7 percent, according to data from Markit, though it is not clear how much of this can be attributed to former CDS investors.
Volumes are also up in European government bond futures, which can still be shorted.
``People are using government bond futures and have been for a while,'' said a London-based investor in hedge funds.
``Trading sovereign CDS was a big winner for hedge funds in the past, but a lot of managers are cautious about playing the sovereign story now because of all the political risk. Saying that, if you want to, then bond futures is the way to go.''
From the authorities' point of view, it leaves euro zone debt - the very market the regulation seeks to protect - especially vulnerable to speculative bets.
Another alternative is to use corporate CDS, which are not covered by the new rules. State-controlled banks or utilities are seen as the best proxies for country risk, though they are less liquid and seen as more risky, making them more expensive.
The net value of corporate bonds protected via CDS on the ITRAXX Europe corporate CDS index has risen 38 percent in the past month, according to data from DTCC.
``It is natural for investors to turn to corporate CDS as an alternative to hedge contagion risk from Europe ... But we are sceptical about such shifts as it costs almost double the spread to hedge with corporate CDS,'' Morgan Stanley said in a note.
A third possibility is to buy options that give the right to sell bonds, stocks or other assets at a later date at a pre-set price. This is the most accurate yet most expensive form of protection but so far Eurex data shows no pick-up in interest.
There are also few signs of investors shifting to non-EU countries, according to Markit, whose benchmark SovX Western Europe index is down 58 percent since March, when the new regulation came into force.
In a bid to salvage the index, it has launched a new ex-EU version from this week but says it has not seen the money that fled the Western Europe index appearing elsewhere.
Sovereign CDS prices and government bond yields have been falling since July, when European Central Bank President Mario Draghi improved sentiment in euro zone bond markets by promising to do whatever it takes to save the euro.
But the fall in sovereign bond yields has been much smaller than the fall in CDS prices: benchmark Spanish yields have fallen by a quarter from a peak before the Draghi comments , while its CDS prices have more than halved.
The different pace in the fall has been in part due to people fleeing the CDS market ahead of the rules.
Michael Hampden-Turner, credit strategist at Citigroup, forecast prices for German CDS - the most popular proxy for euro zone risk, which is already down by two-thirds since March - would fall to 20 basis points from about 26 now. That would take the price to its cheapest in three years.
But the different pace could also indicate that some of that money is shifting into the bond market in the form of shortselling, which keeps bond yields higher than they might be.
The full impact of the new rules will not be felt until the next flare-up in the euro zone crisis strips out the halo effect of the Draghi boost. At that point investors wanting to either protect against or profit from bad news will be more willing to take on the extra cost of the alternatives.
``The effects of the sovereign CDS regulation will be most obvious next time there is a big market sell-off due to sovereign concerns. At that point, we should be able to see whether those entities that are closely aligned to the respective sovereign sell off more than you would have expected them to do,'' JPMorgan's Doctor said.