Don’t end naked credit default swaps in Europe
AT A TIME when the sovereign debt crisis is gripping Europe and threatening to destabilise the global economy, the European Union is considering doing something which would make global debt markets less efficient, less liquid and less transparent – making it more difficult rather than easier for EU states to raise money to fund their activities.
The EU is considering a ban on uncovered (or naked) sovereign credit default swaps (CDS). These are derivative contracts which pay out in the event of a sovereign default and are often used to hedge against just such a default. Many real economy investments in EU states only happen because investors can hedge against the risk of that country defaulting with a sovereign CDS. The sovereign CDS market is also a key indicator of the market’s concern about the ability of individual countries to pay their debts.
A ban is being contemplated because the issue of sovereign CDS has become a political football to be kicked around in Brussels. The European Council, which represents the EU member states, originally took a firm and unanimous position against such a ban. Nearly all EU member states were rightly worried. But the European Parliament is now pushing aggressively for the ban despite a mounting pile of independent research (some of it even commissioned by the Parliament) warning of its negative consequences. Those who support the ban have repeatedly stated that their goal is to hurt “speculators”. They are not talking about more intelligent or even tougher regulation but are using the language of retribution. They do not want to better regulate a market but to undermine it.
The European Parliament has made one nominal concession, which is to allow some hedging use of sovereign CDS. This will be very difficult to implement in practice, as investors will have to prove that whatever investment they are hedging with the CDS is “highly correlated” to the price of cash government bonds in that state. But how can you prove that if you are investing in real or illiquid assets with no publicly available prices?
The consequence of a ban would be an increase in the cost of debt funding for EU member states and a reduction of direct investment in the economies and assets of those member states. Introducing such a ban in an environment where banks are trying to dispose of assets to repair their balance sheets and where governments are trying to raise finances via privatisations is also highly questionable. Restricting the use of CDS will drive down the prices of those assets, as it will be uncertain if investors will be able to use CDS to manage their risks.
Imposing a ban would be both illiberal and counter-productive. It would hurt those it is ostensibly designed to help. And it would also send all the wrong signals about the future economic direction of the EU to the outside world.
Jiri Krol is director of government affairs at AIMA, the global hedge fund industry association.