An Examination of the Impact of the EU Ban on Naked Purchases of Sovereign Credit Default Swaps

Bankers, Markets & Investors, N.147 - Mars Avril 2017

We examine the impact of the November 2012 EU ban on the naked purchasing of EU sovereign credit default swaps (CDS). Using a change point model (CPM), we find thatthe ban directly reduced trading volumes for single-name CDS on EU sovereign linked credit. We show that the ban reduced price correlation between CDS and Eurozone sovereign bonds and we find that the tendency for CDS spread changes to ‘Granger cause’ bond spread changes dropped after the ban, with bond prices then leading CDS prices in most core EU countries. Price discovery now occurs in the bond market. Overall, we see that the EU ban on the naked short selling of EU sovereign CDS has weakened the relationship between CDS and bond prices, making CDS hedging less effective. We suggest that a non-functioning CDS market can lead to an increase
in sovereign funding levels