EU Report: CDS Didn't Cause Sovereign Sell-Off

New developments on the EU debt trading speculation front.


In his latest post, Felix Salmon has excerpted a report that was commissioned by the EU, addressing some of the issues that he wrote about yesterday, and that I later picked up on earlier today:

"First, the results show that there is no evidence of any obvious mis-pricing in the sovereign bond and CDS markets. Second, the CDS spreads for the more troubled countries seem to be low relative to the corresponding bond yield spreads, which implies that CDS spreads can hardly be considered to cause the high bond yields for these countries. Finally, the correlation analysis shows that changes in spreads in the two markets are mainly contemporaneous. The vast majority of countries show now lead or lag behaviour, and when series are not changing contemporaneously, CDS and bond markets are basically equally likely to lead or lag the other. Furthermore, these relationships have been broadly stable over time."


1)There doesn't seem to be any obvious evidence of price manipulation in the sovereign debt markets.

2) Credit default swaps actually seem to indicate less risk than the underlying bonds they reference. (Therefore, derivatives—often a villain du jour in themselves, singled out by politicians in times of crisis—would not seem to be a very rational place to affix blame, for either the deteriorating prices of debt in the secondary markets or rising national borrowing costs.)

3) In case you were unclear about point two, a regression analysis of the timing of price changes between derivates and the bonds they reference would seem to indicate that CDS aren't to blame.

On the idea of "banning naked" in the CDS market, he further quotes:

"Prohibiting naked positions in credit default swaps could dramatically impact the market. If the CDS market is reduced to hedgers only, market liquidity is likely to drop substantially…"

In other words, not only are derivatives not causing the problem—but banning the big meanies who profit from shorting sovereign debt by using CDS could have negative consequences for the market as a whole.

Specifically, it would seem, allowing only hedgers to use CDS would make the market less liquid —which, it might seem reasonable to infer, would actually hurt the hedgers themselves.

Finally, this quote from the report:

"Using temporary bans could prove to be an efficient way of dealing with short-term emergency situations. On the other hand, if temporary bans become a “normal” practice of supervisors, this could create additional uncertainty in the market. If in more volatile situations a ban can be imposed, market participants might price in this uncertainty and bond yields might therefore increase…"

"Another drawback of a ban is that it can send a very strong message to the financial markets about the gravity of the situation of the country(ies) for which the ban will be set in place."

Simply put: Always beware of unintended consequences: Regulation—no matter how carefully conceived or well intentioned—often causes blowback in the marketplace.

And sometimes those regulations redound upon their architects—and seeming benefactors—by sowing the seeds of panic.

Salmon's conclusion: "It’s only natural for issuers of bonds and stocks to complain about speculators and short-sellers whenever those bonds and stocks decline in value; sovereign countries are no exception to this rule. But precisely because such complaints are so natural, they should, as a rule, be ignored. "

Felicitously phrased, Felix.


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