23 July 2012

Anne-Laure Delatte: The European ban on naked sovereign credit default swaps - A fake good idea

The European regulation on short selling and certain aspects of CDSs

As with most financial derivative products, transactions in the CDS market are traded “over-the-counter” as opposed to on a centralised exchange. A new regulation on short selling and naked CDSs will come into effect across the EU in November 2012. Investors willing to trade sovereign CDSs in an EU country must hold the underlying bond or a portfolio of assets correlated to the value of the sovereign debt (a similar ban proposal was debated in the US in 2009 but finally abandoned). The corporate CDSs are excluded from the ban – which is an inconsistency in light of our findings that CDS on banking assets drive market sentiment. The exclusion of banking CDSs clearly introduces a regulatory arbitrage.

More worrying though is an exemption for market-makers, which casts serious doubt about the efficiency of the European regulation. In fact, a market participant is considered a market-maker when her volume of transactions is sufficiently large and she commits to price any transactions an end-user may ask. In other words, large dealers in CDSs, like JP Morgan for example, are market-makers. The point is that this market is highly concentrated, with 87.2 per cent of the CDS trading activity coming from the top 15 dealers (SEC 2012). And the border between market makers and proprietary trading is usually fuzzy in investment banks. In practice, market-makers have an overall view of the market, as they know volumes and price better than anyone else. They often reap the benefits of this competitive advantage in order to carry out proprietary trading activity. In sum, there is a realistic risk that the ban excludes market participants – an activity which is precisely the one that the regulation aims to limit.

Conclusions

Effectively, the advantage of this regulation is that it harmonises the regulation on short selling across the EU. Beyond that, its relevance is questionable in the context of the recently implemented European Market Infrastructures Regulation on over-the counter derivatives. Indeed, the regulation aims to increase transparency in the opaque over-the-counter market along similar lines as the Dodd-Franck act in the US. While it covers all over-the-counter derivative markets, it has been inspired by the specific risk associated with CDSs. It introduces reporting and clearing obligations to promote the standardisation of trades. In the case of a highly-concentrated market such as the CDS market, standardisation and clearing reduce opaqueness and avoid collusion. How then can we explain the adoption of a European ban on CDSs in parallel with the European Market Infrastructures Regulation? The answer may be that a ban draws more attention from the general public. Moreover, it illustrates the inconsistencies of the political process in financial regulation.

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