Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 16 October 2012

The Maginot Line of Sovereign CDS Ban

On 1st of November, the EU ban on buying sovereign CDS will come into effect. This long march against ‘evil speculators’ began with the BaFin ban on ‘naked’ sovereign CDS in May 2010. Wiser council prevailed for a while but could not stop the European parliament tilting at windmills. Therefore about a year ago, the ban was agreed. At that time, there were significant loopholes in the proposals which would have made the ban fairly ineffectual. However, these have since been tightened. For example, earlier any correlated position could be used as justification for buying sovereign CDS. Now buyers have to demonstrate “justifiable” correlation and the position has to be in the country on which sovereign CDS is bought.

Whether the ban will help fund Greece, Portugal, Italy, Spain and at some point France is debatable. The history of short-selling bans provides scarce comfort. But this is more about the political message than anything else. The only problem is that most ‘evil speculators’ have long moved on from CDS. The uncertainty and official vilification which began with the BaFin ban led people to other products to express their views. The subsequent Greek drama did nothing to dispel the dangers of CDS. Moreover with Draghi announcing OMT (the monetisation that dare not speak its name) the probability of a default which triggers CDS dropped sharply. In any case, sovereign CDS only acts as a hedge when the situation becomes distressed but not irreparably damaged. This is because official backlash in the event of collapse will ensure that CDS holders are left holding worthless contracts. 

Interestingly this behaviour is reflected in sovereign CDS market positioning. The net notional, i.e. effective economic interest, on sovereign CDS increased from the beginning of 2010 when Greece slid into crisis. But as the crisis started to spiral out of control by mid-2011 and official scrutiny and talk of banning CDS became more intense, the net notional started to decline. It cratered this September ahead of the November ban and has reached levels which prevailed at the start of 2010 (Graph 1).

Graph 1

Source: DTCC
Ultimately the EU has created a pointless Maginot line to defend against market attacks. The danger is not that high CDS spreads or bond yields will create panic and lead to investor flight since this has already happened. And it has led to increasing fragmentation of financial markets along national lines. This is one of the reasons why ECB is losing control of rates across the Eurozone. If fundamentals don’t recover the optimism created this summer is going to ebb away exposing the EU to further attacks. These would be via capital flight where non-domestic and even some domestic investors withdraw from equity and debt markets. In addition these attacks would be more severe since foreign investors who have been lured back by the OMT are not long-term holders. Prices have moved higher on low trading volume, thus exaggerated price reversals can still take place with or without a ban. Draghi’s OMT gambit is to prevent rather than defend an attack. The OMT will take pressure off CDS and bond yields but at the risk of leaving the Euro exposed. If the ECB is outflanked on the Euro then its defence of Euro-denominated assets is going to prove futile. The Asian crisis showed this in 1997. However it will give European politicians another opportunity to meddle with a heavy hand. Capital controls are the nuclear option.

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