EU decides to ban naked sovereign credit default swaps

Commenting on the EU decision to ban naked sovereign credit default swaps, Professor of Finance at Cass Business School, Ian Marsh, said:

“This ban is based on the accusation that speculating a country will default through trading in credit default swaps actually raises the likelihood of default by increasing the cost of borrowing for the targeted country.  There is probably some truth in this accusation, although regulators are taking a risk as there is not much hard evidence to back up their view.

“Banning speculators from buying insurance while allowing hedgers to do so actually favours the people who made the initial mistake – the banks who lent the money – while harming the speculators who pointed out the problem.

“There are parallels with the short sales bans briefly introduced in 2008/09.  Then, bank share prices were falling and regulators banned the selling of shares that the seller didn’t actually own.  These bans were rapidly reversed in most countries as they did not help to stabilise bank share prices.  Instead, the short sales bans simply made trading shares by those who did own them less easy and more expensive.

“I expect the same will apply to credit derivatives markets.  Banning the speculators will not be costless. Excluding by law a whole bunch of buyers of credit insurance will very likely also reduce the supply of insurance. Legitimate hedgers will then find it harder to get insurance or to reduce their cover should they judge that the situation has improved sufficiently.  And I expect that like the short sales bans, this ban on naked buying of credit insurance will also be quickly reversed.

“EU politicians are talking to two audiences as they impose reforms and regulations.  The first is their electorate where they want to be seen to be doing something about the crisis.  Banning naked CDS writing will seem like a good thing to most of the population.  Their other audience is the financial markets who will, I suspect, see this as another instance of the authorities blaming the wrong people and imposing the wrong policies.”