Most controversial will be measures – strongly advocated by Germany and opposed by the UK – to stop traders buying sovereign CDS as a straight bet rather than as a means of reducing risk exposure on other underlying positions, a step critics argue will further increase sovereign borrowing costs. However, diplomats said the text included a broad definition of hedging and would permit national regulators to lift the CDS curbs for a year or more if they decide sovereign debt markets are not functioning properly.
Under the terms of the deal, investors with financial contracts or a portfolio of assets that are judged to be “correlated” to the value of the sovereign debt will still be permitted to purchase the credit insurance. National regulators can also request for the ban to be lifted temporarily if they can prove that their sovereign debt market is under unusual stress.
To invoke the “opt-out”, regulators submit a case to ESMA, citing evidence such as widening interest rate spreads or poor liquidity in the market. ESMA will offer an opinion but its views are non-binding. “These balanced measures will ensure that sovereign CDS are used for the purpose for which they were designed, hedging against the risk of sovereign default, without putting at risk the proper functioning of sovereign debt markets”, said Michel Barnier, commissioner for the single market. “Short selling did not cause the crisis, but can aggravate price declines in distressed markets.”
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