Call for ban on CDS speculationBy FT reporters
Published: March 10 2010 19:49 | Last updated: March 10 2010 22:26
Germany and France on Wednesday called on the European Union to consider banning speculative trading in credit default swaps and set up a compulsory register of derivatives trading.
The move came as Angela Merkel, German chancellor, called for EU institutions to be given “more teeth” both to control speculation and to police the deficit spending of member states. François Fillon, French prime minister, said after talks in Berlin that both governments were “very much in agreement in tackling extreme speculation”.
Regulators face CDS headache - Mar-09
The two leading economies in the eurozone are asking for an immediate investigation of the role and effect of speculative trading in CDSs in the sovereign bonds of European Union member states. Their request came in a letter sent on Wednesday to José Manuel Barroso, president of the European Commission, and José Luis Rodríquez Zapatero, Spanish prime minister and current chairman of the EU ministerial council.
As an alternative to a ban on speculative trading in CDSs they suggest a bar on so-called naked transactions, in which investors buy swaps without holding a direct investment in the underlying debt, and tighter regulation of short-term swaps in the bond markets.
A growing European consensus on the need for tougher regulation of CDS trading was reflected by Lord Turner, chairman of the UK Financial Services Authority, who warned that naked trading in corporate CDSs could force companies into default.
CDS market
The Franco-German initiative, backed by Luxembourg and Greece, also calls for regulators to be given “unlimited access” to a register of derivatives trading in order to identify who is trading and what they are doing.
It proposes that derivatives transactions should only be allowed on exchanges, electronic platforms and through centralised clearing houses.
CDSs are commonly used by banks and hedge funds to reduce their risk, but they are also popular with investors who buy and sell them with an eye to making a quick profit.
Naked CDSs have been blamed for helping driving down Greek bonds this year and financial companies last year.
Lord Turner, who is also a member of the Financial Stability Board, which works on global regulatory proposals, said he wanted regulators to look at the question of naked CDSs on both corporate and sovereign debt.
“We need to think about whether we are being radical enough on credit default swaps . . . as to whether naked CDSs should be allowed,” Lord Turner said, adding he was particularly concerned that corporate CDSs could be manipulated to force a company into default, a form of market abuse.
But he warned against hasty action. “We need to look at these issues very carefully. There is a danger of an oversimplistic belief that everything going on is shorting in the CDS market,” Lord Turner said.
In a clear indication of the gathering international support for action, Mario Draghi, chairman of the FSB, signalled this week that the group was focused on the issue.
“This way of betting has systemic implications,” he said.
“The sense I have is that governments are increasingly uneasy with this. Whenever something has systemic implications, you can bet it is going to get systemic regulation.”
Reporting by Quentin Peel in Berlin, Brooke Masters and Sam Jones in London, Aline van Duyn in New York, and David Oakley
The problems with derivative regulation
Why has the controversy over credit derivatives blown up?
The Greek budget deficit crisis has focused attention on the market because of accusations that speculators used it to cause a sell-off in the Athens debt and stock markets and made large sums from violent moves in prices.
So what is a credit derivative?
Otherwise known as credit default swaps (CDS), it is a contract between two parties. One buys protection against a certain bond defaulting, while the other sells protection in a swap agreement. Buying a CDS contract is not the same as buying an insurance contract, but it does reduce market risk for a buyer.
Why have calls for regulation increased?
The Greek deficit crisis has prompted some politicians to demand more oversight and restrictions of the market. However, moves to regulate the market have been in motion since the financial crisis because it is considered too opaque and murky as it is traded privately, or over-the-counter, and is difficult to track.
Is a credit derivative used for speculation or to hedge risk?
Both. This is where problems exist in regulating the market as hedging risk is considered a legitimate use of the instrument. However, it is difficult to differentiate between funds that are speculating to make quick profits and those that are trying to reduce their risks by buying CDS protection.
What type of regulation is likely?
It seems certain that regulators will force CDS to become a public market by making banks and funds trade them on exchanges or through clearing houses, which will oversee and publish trades.
Naked CDS trading is also under attack. What’s that? This is trading a CDS contract by a bank or hedge fund that does not own the underlying bond or related security. Some politicians blame this kind of trade for exacerbating the Greek deficit crisis as they say it is purely speculative and designed to make quick profits mainly by hedge funds.
Will naked CDS trading be banned?
This could prove tough and regulators are increasingly against it because it is difficult to define.
Will regulations be co-ordinated globally?
The Basel-based Financial Stability Board is co-ordinating the G20’s response to the financial crisis and will try to encourage similar regulations in different jurisdictions. If regulations are not co-ordinated globally, then traders will simply migrate to the markets where there are no regulations.
