The EU debunks the debt-speculation meme

By Felix Salmon
December 9, 2010
have you think so. And indeed the EU was so worried about the possibility of manipulation in the sovereign CDS market that it commissioned a comprehensive report on the subject.

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Is the market in European sovereign debt rife with speculation? The NYT would have you think so. And indeed the EU was so worried about the possibility of manipulation in the sovereign CDS market that it commissioned a comprehensive report on the subject.

Wonderfully, Martin Visser of Dutch newspaper Het Financieele Dagblad managed to obtain a copy of the report, using the European equivalent of a FOIA request. His article is here; a Google-translated version is here; and the actual report — a 6MB PDF file, I’m afraid — is here. (For all of these links I’m highly indebted to @ldaalder.)

You can see why the EU might have wanted to keep the report secret: it concludes that the sovereign CDS market is a force for good, and that curtailing it in any way is likely to be a bad idea. Here’s part of the executive summary:

First, the results show that there is no evidence of any obvious mis-pricing in the sovereign bond and CDS markets. Second, the CDS spreads for the more troubled countries seem to be low relative to the corresponding bond yield spreads, which implies that CDS spreads can hardly be considered to cause the high bond yields for these countries. Finally, the correlation analysis shows that changes in spreads in the two markets are mainly contemporaneous. The vast majority of countries show now lead or lag behaviour, and when series are not changing contemporaneously, CDS and bond markets are basically equally likely to lead or lag the other. Furthermore, these relationships have been broadly stable over time.

The report goes on to look specifically at the idea of banning “naked shorting” in the CDS market:

Prohibiting naked positions in credit default swaps could dramatically impact the market. If the CDS market is reduced to hedgers only, market liquidity is likely to drop substantially…

Under a permanent naked CDS ban, CDS would possibly become more classical insurance devices, i.e. customised to closely-related exposure. This would reduce the market’s ability to trade credit risk and, make proxy-hedging impossible. As a result, the cost of bond market financing for the broader economy could increase…

Overall, it is not clear how the bond market would be affected by a ban on naked CDS. Moreover, there are substitute strategies to bet on a downturn in sovereign risk: sell a future on the bond, buy a put option, sell a call option, short sell the bond are usual investment techniques…

Using temporary bans could prove to be an efficient way of dealing with short-term emergency situations. On the other hand, if temporary bans become a “normal” practice of supervisors, this could create additional uncertainty in the market. If in more volatile situations a ban can be imposed, market participants might price in this uncertainty and bond yields might therefore increase…

Another drawback of a ban is that it can send a very strong message to the financial markets about the gravity of the situation of the country(ies) for which the ban will be set in place.

It’s only natural for issuers of bonds and stocks to complain about speculators and short-sellers whenever those bonds and stocks decline in value; sovereign countries are no exception to this rule. But precisely because such complaints are so natural, they should, as a rule, be ignored. Even the EU, when it investigated the situation, came to the conclusion that market manipulation is not the problem here: the market is simply doing its job of pricing credit risk. If anything, the market failure took place in the past, when investors (especially European banks) were not properly pricing credit risk.

I don’t blame the NYT for missing a report in a Dutch newspaper, but I’m still stumped as to the source of its assertion that Dominique Strauss-Kahn has been warning about speculation in European sovereign debt. Because the fact is that if you’re looking at the views of big international organizations, the consensus would seem to be that speculation is actually nothing much to worry about at all.


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