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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I think it depends on your definition of speculitive. I think it is a very safe bet that states which have deficits larger than 25% of their budget and high debt per capita will not vollentarily meet their obligations.

To buy debt of those U.S. States or European countries like Greece is more of a speculation (that your debt will be repaid via a 3rd party) than an investment that Illinois or Ireland will directly pay you what you are owed.

Posted by y2kurtus | Report as abusive

Doesn’t the US have a deficit in excess of 25% of its budget? And pretty high debt per capita? Are you suggesting it is a very safe bet that the US will default?

Posted by TFF | Report as abusive

The alleged moderator of these comments seems to be out bird-watching.

Posted by walt9316 | Report as abusive  /2010/12/cds-ex-machina.html

If governments were so unhappy about the CDS market and confident that the wide spreads at which Greece CDS were trading exaggerated the default risk of the Hellenic republic bonds, then there was a clear course of action open to them.

They should have stepped in and sold 10 or 20 billion euros of Greek protection themselves at the height of the market – about 1000bps or 10% per year. Not only would this demand to sell protection on Greece have driven in Greek default swap spreads, they would in the process have bankrupted all the so-called speculators and made a killing for their respective governments.

The fact that they didn’t speaks volumes.

Posted by Domination | Report as abusive

I for one do not understand why we continue to view CDS markets in such a positive light. It is as though we had so much fun taking an unexpected baseball bat to the skull that we think everyone should have a baseball bat.

Hugh Hendry reports in his December shareholder letter (which should be required reading for anyone who believes in CDS markets –> FELIX) that Japanese banks which earn just about nothing on JGBs are amping things up by selling sovereign CDS protection. So that’s who took over where AIG left off! 473-the-Eclectica-Fund-Manager-Commentar y-December-2010)

Which is really poignant. As Japan marches bravely into its own debt-armageddon, it earns pocket money along the way by swallowing live grenades. I love Japan very much and only a nation as awesome as them could carry out such a beautifully macabre death dance.

(1) Who thinks these CDSs sold by Japanese banks are priced properly?
(2) Who thinks these Japanese banks will be able to pay up for sovereign defaults when that firestorm envelops Japan?

Posted by DanHess | Report as abusive

@y2kurtus I believe you meant 25% of GDP, since the relationship between a country’s deficit and a country’s budget would seem to be irrelevant with regards to the likeliness of default. Also, although there are some similarities between poorly run US states and poorly run European countries, I believe the differences are probably more important. The main one being European countries are currency issuers, whereas US states are not.

@Domination Your point is well taken, however, regarding your last statement, I believe their inaction is more likely to have stemmed from their worse than vague understanding of how their own economic system works than from their opinion of the future of Greek debt.


Posted by CavelCap | Report as abusive

In response to Dan Hess I would state that anyone who buys Japanese protection from a Japanese bank needs their head examined unless the counterparty risk of the trade is highly collateralised. This is an example of “wrong-way risk”. I tried reading the Hendry report but must confess that I found it so pretentious I had to stop. I am not sure he is credible.

Posted by Domination | Report as abusive

To clarify the two points raised by Dan Hess and CavelCap:

For D.H. As the U.S. issues debts only in its own currency there really can’t be a traditional default. They will try and slowly inflate their way out of the debt… it’s worked since 1913 but I doubt it will go on for another 100 years. I see 10% plus inflation within 10 years.

for Cavelcap: some European countries (U.K. Swiss) issue currency, Most do not (Euro). The Greek, the Spanish, the Italians, can’t print there way out of trouble. They need to either exit the Euro than devalue than reduce wages or else swallow some very bitter pills… like 40% budget cuts… not easy.

Sorry to respond so late in the thread!

Posted by y2kurtus | Report as abusive