-Kevin Dugan
The European Parliament voted to all-but-ban short selling and naked credit default swap trading on sovereign debt—albeit with some seemingly large loopholes and details left fuzzy. The intention is to control volatility and speculation, as politicians are blaming CDS for exacerbating the sovereign debt crisis.
What is considered a naked play—that is, when a trader doesn’t own any of the underlying assets the swap is based on—is set to be defined down the road. For instance, a stake in an Italian bank is equated with buying into the country’s bonds because “in the event of [an] Italian default, Italian banks would certainly suffer significantly,” according to an explanation of the vote released by the European Parliament. The rules are set to go into effect in Nov. 2012.
“The exposures seem to be so vague that if you really want to, you can buy anything,” said one London CDS trader. “It will be frictional in the sense that it will make it slightly more difficult,” said another sovereign CDS trader in London. Because the rules have yet to be clarified, no one is certain exactly what kinds of exposures will allow a counterparty to be considered covered, but traders don’t seem very worried about the legislation so far. “It’s not going to change the market making business. It’s not going to change banks transacting with each other on sovereign risk.”
In May, Germany temporarily banned naked CDS trading, but one way to get around the ban is by basing the trades in London. “I suppose the ban isn’t particularly effective,” one CDS trader said. “It doesn’t stop users from buying sovereign CDS.” Since London would presumably be under the European Parliament’s rules, though, traders asked were still uncertain about similar procedures could take place and were waiting for the law to be more finely defined.
Pascal Canfin, a Member of European Parliament who has championed this legislation, said he was not yet able to quantify or qualify what would count as covered, as the rules are going to come into focus as a commission of member states will more clearly define them. But what about naked CDS trading? “As a principle, you cannot trade a naked CDS contract even if the trade is located in Hong Kong or New York,” he said. Not only would it be illegal, Canfin expects other regulators, such as the U.S. Securities and Exchange Commission, to work with the European Parliament on enforcing the rules. An SEC spokesman was not immediately available to comment on whether the regulatory body will work with the European Parliament to curb naked CDS trades on European sovereign debt.
