Liquidity falls as "naked" CDS ban approaches

Fri Oct 19, 2012 9:31am EDT

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(This story previously appeared on IFRe.com, a Thomson Reuters publication)

By Christopher Whittall

LONDON, Oct 19 (IFR) - Liquidity in sovereign credit default swaps has cratered ahead of a controversial EU ban of outright short positions set to come into force in less than two weeks' time on November 1.

The net notional outstanding of EU sovereign CDS has plummeted to its lowest level since records began of around USD112bn from over USD140bn in 2011 when the eurozone crisis intensified last year.

Credit experts see it as a direct result of the new rules that prohibit outright shorts via sovereign bonds or CDS, which were voted into law on March 25 this year. Dealers predict the rules will also kill off the Markit's SovX Western Europe index, which has seen volumes tail off dramatically over the past year.

Dealers have complained that much confusion remains over the application of what they see as an unnecessary ban and predict that clients will sit on the sidelines rather than risk falling foul of the new regulations.

"The regulations are causing a natural compression in notionals right now as people get their heads around the relatively fluid developments from the regulators," said one head of sovereign CDS trading at a European bank. "The market will and should err on the defensive side - the last thing anyone wants is to appear on the front of the newspaper accused of flouting the rules."

The rules are complex for sovereign CDS users. Hedges will have to pass both a quantitative test (showing 70% correlation between an investor's exposure and the price of the sovereign debt in question) and qualitative tests, which are supposed to demonstrate a "meaningful correlation" using "appropriate data".

Dealers indicate investors may turn to shorting bonds instead, where it is easier to demonstrate compliance with the new rules.

"Nobody knows what 'meaningful' means in practice - it's not at all clear," said one legal and regulatory expert at a US bank. "ESMA were supposed to just put the meat on the bones of the regulation but they've over-stretched themselves and made it more restrictive."

"It feels like a one-size fits all policy that covers equity, credit and rates," added the sovereign CDS trader. "But I'd imagine they won't lose much sleep if it doesn't fit well for CDS - I'm not sure it's a high priority in terms of markets they feel are crucial to the smooth transmission of capital around the world."

Dealers say they have now received their market-making exemptions for the ban. However, investors will be more restricted in their use of sovereign CDS than before. In particular, sovereign CDS as proxy hedges or for sovereign cross-border exposures will no longer be allowed.

"Our conversations with market participants indicate that most are still unprepared for [the new rules]", wrote JP Morgan credit analysts in a recent research report.

Many analysts argue European emerging market sovereign CDS - where hedge funds have traditionally provided more liquidity - will be hit hardest, while larger countries such as Italy, Germany and France are expected to be less affected.

Sovereign issuers will watch with interest if the ban affects their forays into the primary market. In any case, the JP Morgan analysts argue liquidity will be negatively impacted "across a number of financial instruments". (Reporting by Christopher Whittall, Editing by Helen Bartholomew)

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