June 18, 2012 / 8:32 AM / 5 years ago

Watchdog says jury out on CDS short-selling impact

LONDON (Reuters) - There is no firm proof that short-selling credit default swaps (CDS), blamed by some policymakers for exacerbating Greece’s debt problem, damages the underlying government bond market, the world’s top securities body said.

CDS are contracts written by large banks that insure the buyer against a default in an underlying asset such as a government or corporate bond.

“There is mixed evidence on the impact of CDS on the orderly functioning of the primary and secondary markets of the underlying bonds and on creditor incentives, although the CDS market is found to have an important role in the price discovery process,” the International Organisation of Securities Commissions (IOSCO) said in a report.

Leaders of the G20, who meet in Mexico on Monday and Tuesday, asked for the study from IOSCO, whose members include the U.S. Securities and Exchange Commission, Japan’s Financial Services Agency and Germany’s Bafin.

Many European Union politicians argued in 2010 that hedge funds short-selling CDS linked to Greek debt made it more costly to put together the country’s first bailout package.

It led to the EU approving a law to ban “naked” short-selling of sovereign CDS from November this year. A naked or uncovered CDS contract is one where the buyer does not own any of the underlying asset being insured from default.

The EU law proved so controversial that member states insisted on being allowed to opt out and IOSCO appeared to back their concerns.

“To date, there is no conclusive evidence on whether taking short positions on credit risk through naked CDS is harmful for distressed firms or high-yield sovereign bonds,” IOSCO said.

The gross notional value of CDS contracts at the end of 2011 was $26 trillion. The G20 agreed at the height of the 2007-09 financial crisis that CDS and other off-exchange traded derivatives transactions should be centrally cleared and recorded by the end of this year.

A “non-negligible amount” of CDS contracts are already being centrally cleared and recorded in the EU and United States.

“In summary, the amount of CDS trading has continued to increase even after the onset of the financial crisis, while standardization and risk management practices have significantly expanded,” IOSCO said.

There is some evidence the CDS market is under-collateralized, it added.

Editing by David Holmes

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