ANALYSIS – EU focus on credit default swaps may not yield bans

By Reuters Staff
March 5, 2010

By Huw Jones

LONDON, March 5 (Reuters) – European governments are exploring ways to curb trade in credit default swaps but may have to settle for requiring greater disclosure rather than banning certain forms of speculation.

France, Germany and Luxembourg say “speculators” — typically code for hedge funds — used CDS contracts to bet on Greece defaulting and send the euro lower.

Faced with such political pressure, the European Commission has called national supervisors, credit rating agencies, hedge funds and investors to meetings in Brussels on Friday to help it decide if European Union action is needed in the CDS market.

The U.S. Justice Department is also investigating if hedge funds might have acted together in betting against the euro.

Credit default swaps are privately-negotiated “insurance” contracts between two parties. Unlike normal insurance, the buyer can go “naked”, not owning what is being insured, a situation regulators say is perverse.

Traders are waiting to see if regulators will go beyond jawboning and require buyers of sovereign CDS to own some underlying debt or deploy other means to quell volatility.

“In principle it would be feasible to design a scheme that would prevent financial institutions from being involved in the naked sale of CDS,” said Karen Anderson of Herbert Smith lawfirm.

Politicians like French Economy Minister Christine Lagarde and Eurogroup President Jean-Claude Juncker of Luxembourg have argued that the CDS tail is wagging the sovereign debt dog.

Financial lawyers, industry officials and analysts say CDS contracts are a health check on the underlying asset and governments just can’t stomach the truth of falling prices.

“The question is how much difference (curbs on CDS) would really have made to the market in Greek debt. Abusive practice could be dealt with under market abuse rules, assuming you can prove it,” Anderson said.

MANIPULATING MARKETS

There are $9 billion of Greek sovereign CDS outstanding relative to $406 billion of government bonds — too little to put pressure on the debt price according to Citi bank analysts.

“Targeting rules specifically at CDS could be made legally effective but would be very unlikely to have any material effect,” said Simon Gleeson, a partner at Clifford Chance.

“It also raises the larger issue of the extent to which it is appropriate or sensible to seek to use regulation to manipulate markets,” Gleeson added.

Banning naked sales of CDS would be more complicated than the introduction of curbs and disclosure rules on shorted shares and costlier for the holder.

If a CDS buyer decided to sell the underlying bond he was forced to buy, he would then have to close out the contract which could be at a big loss.

“These are long-dated derivatives that can be traded from multiple jurisdictions which would require a globally coordinated response,” Citi said.

As Europe’s biggest trading centre, a ban on naked CDS selling would hit London most and Britain’s market watchdog has not surprisingly been more measured in its comments.

Financial Services Authority Chairman, Adair Turner, said this week that naked CDS sales are one of several factors hitting Greek bonds and should not be overstated.

Many long investors were not willing to buy and there was also a confidence question about Greece, Turner said in comments seized on by the industry.

“A CDS contract does not exist without a long position as well, so why are people only focusing on the short position?” said Richard Metcalfe, global head of policy at the International Swaps and Derivatives Association.

“CDS prices provide information about credit appetite, even when bond markets are effectively shut, as was the case during certain periods in 2007-08,” Metcalfe said.

MORE TRANSPARENCY

Policymakers are already requiring central clearing of as many CDS contracts as possible.

The U.S. Depository Trust and Clearing Corp publishes data on aggregate global CDS positions and regulators could insist that naked positions above a certain threshold are reported to regulators and the market.

An outright ban would make it impossible to use sovereign CDS to diversify portfolios and have unintended supervisory consequences, said Ed Parker of Mayer Brown law firm.

“A credit default swap where the buyer is obligated to hold the underlying asset starts to look like an insurance contract. Only insurers are regulated to write insurance contracts, so if this goes through, expect some other regulatory headaches,” Parker added.

A ban risked creating product regulation because of political perceptions rather than genuine need, Herbert Smith’s Anderson said.

The many investors using sovereign CDS to hedge legitimately would probably react to any ban by selling bonds, Citi warned.

“We are not convinced that the market has the negative effect on bonds that people tend to think, nor are we convinced a ban would work,” Citi said.

(Reporting by Huw Jones; Editing by Ruth Pitchford)

((Reuters messaging: huw.jones.reuters.com@reuters.net; + 44 207 542 3326; huw.jones@thomsonreuters.com))

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