May 19, 2010 / 8:59 PM / 10 years ago

German short sale ban may broadly reduce CDS trading

NEW YORK, May 19 (Reuters) - Germany’s surprise ban on short sellers sparked concerns over the potential impact of new regulations in credit markets and could have a broad impact on the liquidity of credit default swaps.

Corporate credit indexes weakened, though sovereign indexes rallied, after Germany on Tuesday said it would ban naked short-selling of shares in its 10 top financial institutions, naked short sales of euro zone government bonds, and so-called naked transactions in credit default swaps (CDS). For details, see [ID:nSGE64I073].

Credit default swaps are used to protect against losses if a borrower defaults on its debt, or to speculate on their credit quality. The contracts are deemed “naked” if a buyer of protection does not also own the bonds backing the swap.

The move “highlights the risks linked to more stringent government regulations,” JPMorgan credit analysts said in a note. “We believe that the ban should lead to a much reduced liquidity in economic and monetary union countries sovereign CDS and to lower liquidity in corporate CDS as well.”

Politicians including Greek Prime Minister George Papandreou have criticized CDS and said that volatility in the contracts helped drive up borrowing costs that exacerbate fiscal challenges facing governments.

Defenders of the market counter that rising borrowing costs for the countries reflect legitimate concerns over ballooning debt holdings, and that the ability to hedge exposures with CDS is important for maintaining demand for sovereign debt.

The German ban “was somewhat of a sign of market desperation, which you never want to show,” said Mikhail Foux, strategist at Citigroup in New York. However, “it does show (regulators) are being really proactive in what they are trying to do, which is more of a positive.”

Volumes in CDS on many sovereign debt names have risen in tandem with concerns over the ability of some countries to manage their finances, and the cost that other countries will need to pay to support them.

Net CDS volumes on the debt of the United Kingdom have jumped to $10.21 billion, from $3.89 billion at the beginning of the year, according to the Depository Trust & Clearing Corp, a trade warehouse.

Contracts on France’s debt also increased to $10.93 billion, from $9.27 billion at the beginning of the year and CDS on Germany has increased to $13.39 billion from $11.99 billion in the same time frame.

There is no data on what portion of the market constitutes “naked” positions, though some estimates put the number at around 80 percent of the market. In many cases the contracts are used to hedge risks associated with a country that are not directly associated to its debt.

Banning uncovered trades may significantly reduce the liquidity available for investors looking to hedge their positions, as well as make it harder for participants to exit existing trades.

To unwind a CDS transaction an investor can tear up the contract and pay or receive cash owed, or enter into an offsetting trade to neutralize the exposure.

Attempts to unwind a contract with cash payments can be complicated as counterparties owing money on the trade may be reluctant to pay out the contracts.

An investor that has a short position and wants to offset the exposure, meanwhile, would need another counterparty that holds the debt to take the short side of a trade.

“This limits the potential number of counterparties and pricing should be distorted as the sovereign CDS market would be dominated by entities who own sovereign debt,” JPMorgan said.

Volumes in corporate CDS, meanwhile, may also fall as investors fret over the form of further regulatory intervention in the market.

“Investors might be wary of using corporate CDS as an instrument to express their views because the possible intervention of financial regulators might force them to unwind their positions,” JPMorgan said.

Editing by Kenneth Barry

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