11 April 2013

IMF: A new look at the role of sovereign credit default swaps

Summary

The debate about the usefulness of sovereign credit default swaps (SCDS) intensified with the outbreak of sovereign debt stress in the euro area. SCDS can be used to protect investors against losses on sovereign debt arising from so-called credit events such as default or debt restructuring. SCDS have become important tools in the management of credit risk, and the premiums paid for the protection offered by SCDS are commonly used as market indicators of credit risk. Although CDS that reference sovereign credits are only a small part of the sovereign debt market ($3 trillion notional SCDS outstanding at end-June 2012, compared with $50 trillion of total government debt outstanding at end-2011), their importance has been growing rapidly since 2008, especially in advanced economies.

With the growing influence of SCDS, questions have arisen about whether speculative use of SCDS contracts could be destabilising. Such concerns have led European authorities to ban uncovered, or “naked”, purchases of SCDS protection referencing European Economic Area sovereign debt obligations, that is, banning purchases in which there is no offsetting position in the underlying debt. The prohibition is based on the view that, in extreme market conditions, such short selling could push sovereign bond prices into a downward spiral, which would lead to disorderly markets and systemic risks, and hence sharply raise the issuance costs of the underlying sovereigns.

The empirical results presented in this chapter do not support many of the negative perceptions about SCDS. In particular, spreads of both SCDS and sovereign bonds reflect economic fundamentals, and other relevant market factors, in a similar fashion. Relative to bond spreads, SCDS spreads tend to reveal new information more rapidly during periods of stress, though not typically at other times. The use of SCDS as proxy hedges for other types of credit risks (notably for financial and non-financial corporate bonds) means that spillovers to other markets are inevitable. Whether SCDS markets propagate contagion is difficult to assess since the risks embedded in SCDS cannot be readily isolated from those in the financial system. However, SCDS markets do not appear to be more prone to high volatility than other financial markets. While there are some signs that SCDS overshoot their predicted value for vulnerable European countries during periods of stress, there is little evidence overall that such excessive increases in countries’ SCDS spreads cause higher sovereign funding costs.

The IMF goes on to state emphatically that the naked CDS ban in Europe is a policy mistake: Overall, the evidence here does not support the need to ban purchases of naked SCDS protection. Such bans may reduce SCDS market liquidity to the point where these instruments are less effective as hedges and less useful as indicators of market-implied credit risk. In fact, in the wake of the European ban, SCDS market liquidity already seems to be tailing off, although the effects of the ban are hard to distinguish from the influence of other events that have reduced perceived sovereign credit risk. In any case, concerns about spillovers and contagion effects from SCDS markets could be more effectively dealt with by mitigating any detrimental outcomes from the underlying interlinkages and opaque information. Hence, efforts to lower risks in the over-the-counter derivatives market, such as mandating better disclosure, encouraging central clearing, and requiring the posting of appropriate collateral, would likely alleviate most SCDS concerns.

Press release

Full report

Further reporting by Euromoney

© International Monetary Fund