From the April 01, 2011 issue of Futures Magazine • Subscribe!

EU bans naked CDS

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In another example of the growing trend to blame rising prices on speculators, European Union (EU) lawmakers approved a ban on naked credit default swaps (CDS) of sovereign debt. The measure now must be approved by the individual countries.

As the cost of borrowing money in peripheral nations has risen, the blame has fallen on speculators because CDS are used as a benchmark for the value of a nation’s debt. Lawmakers are asserting speculator activity is deepening the European sovereign debt crisis.

"Absolutely, [speculators are being blamed]. Plus, CDS have been the whipping boy of the financial crisis right from the beginning when clearly the root cause was much more complicated than that," says Kevin McPartland, senior analyst at Tabb Group.

While the law does make an exemption for hedge funds that hold a proxy "asset or portfolio of assets" that show a high correlation with government bond prices, the move is being seen as largely politically driven. "The public view is ‘Of course this is a bad thing; we don’t want someone shorting our country.’ That misses out on some of the real economic reasons why these products were created in the first place," McPartland says.

If the measure is passed, the European Securities Markets Authority (ESMA) still would need permission of the nation in question if it wants to ban naked selling of sovereign CDS linked to its debt.

Hedge funds and other market participants are saying liquidity may disappear and may hurt nations’ debt problems even more. "Debt markets would be less efficient, liquid and transparent. The cost of borrowing would increase and the availability of credit to borrowers would decrease, with a concomitant negative impact on growth and jobs," says Andrew Baker, CEO of the Alternative Investment Management Association (AIMA).

Germany unilaterally introduced a ban on naked selling of CDS last year, which was due to expire in March 2011.

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