Speculating on the creditworthiness of a European country, and protecting against a default, has just got a lot more difficult.
On November 1, a new short-selling regulation (SSR) designed to curb speculation using the bonds and credit default swaps of European sovereigns was applied across the European Economic Area, some eight months after it first came into force.
The new regulation restricts the short selling of sovereign bonds and sovereign CDS, as well as shares – the first time rules on short selling have been harmonized across the European Union, and Iceland, Liechtenstein and Norway to boot.
For some governments, this is a necessary development.
The short selling of sovereign bonds and sovereign CDS, in particular, has been seen to exacerbate the eurozone sovereign debt crisis, forcing up the borrowing costs of countries such as Greece, Ireland, Italy, Portugal and Spain to unsustainable highs.
By applying a ban on short selling the EU is therefore trying to ensure that sovereign borrowing costs are not inflated by speculators using the CDS market.
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However, while the EU seems reasonably clear on what this new regulation will achieve, the market is anything but. As with the application of so much new financial regulation, unintended consequences abound. "Unwittingly, this legislation may actually drive government bond yields up, instead of down as intended, because of the illiquidity it has created in the sovereign CDS market," says Virginia Laird, legal and regulatory business risk manager for Europe, the Middle East and Africa, at Citi in London.
Few investment banks would disagree with that assessment, especially the impact the regulation is having on liquidity.
Saul Doctor, head of European credit derivatives strategy at JPMorgan in London, says: "We have already seen falling net notional outstanding in sovereign CDS and distortions in the pricing of CDS on those sovereigns that are impacted by the regulation relative to their peers."
Belle Yang, senior sector specialist, credit trading, at BNP Paribas in London, adds: "Liquidity in the current series of SovX has already dropped to minimal levels due to a combination of anticipation of the SSR ban and the inability of SovX to react quickly to market movements in the more volatile sovereign credits."
Trading volumes in the iTraxx SovX Western Europe index – which tracks the cost of insuring against government bond defaults in 14 European countries – have almost flat-lined, according to data provider Markit.
At its simplest, the new regulation will mean the following for the trading of sovereign CDS and sovereign bonds: market participants can only buy protection through EU Sovereign CDS when they have either a long position in the sovereign debt or to an exposure to a correlated asset in the same country, which is classified as a ‘covered’ position; and on the cash side, investors cannot short sell an EU sovereign bond unless they have either located or have a reasonable expectation that settlement can be effected when due.
However, the new regulation does raise many more questions than it seeks to answer and liquidity in sovereign CDS is not the only area likely to be affected.
Market-makers could take a hit as well, impacting liquidity and pricing in other areas.
"One of our main concerns... is that the market-making exemption may be interpreted very narrowly requiring instrument by instrument exemptions or a persistent market-making presence leading to less liquid markets in sovereign bonds and equities," says Doctor.
Should regulators require an instrument-by-instrument exemption and a persistent market-making presence this will discourage dealers from trading new-issue bonds and equities, reduce the number of market-makers of each instrument and make illiquid instruments more illiquid.
Of course, it could ultimately reduce the number of market-markers too, which may contribute to "wider bid-ask spreads", says Doctor.
Another potential effect could be the rise in so-called proxy hedging.
"Those investors who would otherwise have used sovereign CDS as an easy macro hedge will look to proxies such as CDS on European banks as an alternative, particularly for cross-border trades where the parameters in the SSR are very restrictive," says Yang.
"This will undoubtedly increase the volatility in CDS on Giips [Greece, Italy, Ireland, Portugal and Spain] systemic banks, which are highly correlated proxies with the sovereign."
Utility companies could be affected too, says Doctor.
In sum, market participants warn that central banks and treasuries could ultimately be impacted most because, as a result of this new regulation and the confusion it has created, the cost of funding could be expected to rise as counterparties pass on increased costs due to the illiquidity.