(This story previously appeared on IFRe.com, a Thomson Reuters publication)
By Christopher Whittall
LONDON, Oct 31 (IFR) - Soaring volumes in European government bond futures have exposed a flaw in EU regulation designed to halt speculators from driving up funding costs in the periphery by shorting government debt.
A ban on "naked" short positions in European sovereign credit default swaps is set to come into force tomorrow, causing many participants to steer away from the sovereign CDS market to hedge or take views on the eurozone.
But far from being prevented from shorting vulnerable sovereigns, investors have found a simple way to skirt around the rules by shifting positions into exchange-traded government bond futures that are not subject to the new regulation.
Open interest in Eurex-listed Italian BTP futures has almost doubled since the announcement of the ban back in March, from 32,271 to a new peak of 62,489.
Volumes in OAT futures have rocketed even more sharply with open interest reaching a high of 146,923 on October 24 despite the contracts only launching in April.
"The growth in futures volumes is unbelievable," said one senior credit trader. "The same short interest still exists - economically it's identical. If you thought the short interest was hurting the market then it makes no sense to say cleared derivatives are good and OTC derivatives are bad."
Dealers have expressed concern that the EU ban could severely damage the sovereign CDS market, which is viewed by many as supportive of government bond markets. Volumes have already tumbled, with the net notional in EU CDS dropping from a peak of just under USD140bn net notional outstanding in mid-2011 to around USD112bn currently.
Experts say the effects are becoming particularly notable in central and eastern Europe sovereign CDS, where the cash-CDS basis has already tightened considerably.
Meanwhile, analysts at Morgan Stanley calculated there had been USD286bn of net new trading in western European sovereign CDS since the ban was announced, estimating that further position unwinds would be necessary to comply with the rules.
The ban has also caused a shake-up in the index market, with Markit's iTraxx SovX Western Europe index likely to get scrapped as a result of not complying with the new regulations, and its CEEMEA index omitting EU names in order to survive.
Bankers have expressed bemusement at the clear inconsistencies in the new rules, with regulators allowing futures while shunning CDS shorting, although some reckon it is yet another sign of regulators favouring exchange-traded markets over OTC business.
"Futures are cleared, and people like that. It will also stop the "big bad" OTC guys doing their stuff," said the senior credit trader. (Reporting by Christopher Whittall, Editing by Helen Bartholomew)