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