The EU End Game: Regaining Control

It is one week left before the top leaders of the European Union get together in Brussels for their most important meeting so far. The European debt problems has to be solved; at least a realistic plan that every member state can accept has to be put on the table. The outcome of next weekends summit will determine the future of the union. It’s make or break time. This the first of a series of articles focusing on possible solutions – this is the final countdown.

“The EU ban on naked sovereign CDS may be a signal that regulators and legislators now understand the issues and are prepared to address them, bringing about meaningful reform in the control of derivative trading.”

Satyajit Das

“Predictably the EU ban on “naked” credit default swap (“CDS“) contracts on sovereigns has brought forth an angry response from dealers and the industry body ISDA (International Swap & Derivatives Association). Just as “patriotism is the last refuge of a scoundrel”, arguments citing market efficiency and the benefits of speculation seem to be the first resort of dealers,” Satyajit Das at


The EU leaders have lots of important issues to discuss next weekend, but we have to start somewhere so why not with the new regulations and the demonized Credit-default swaps?

Former derivative trader  Satyajit Das with the knows what he’s talking about.

Here’s Mr. Das proposal on how to deal with the problem:

The familiar case was that prohibition was unnecessary, would decrease liquidity, increase borrowing costs and create greater uncertainty for European firms. The arguments are self-serving and do not present a balanced view of the issues.

The EU rule does not impede genuine hedging. If an investor owns sovereign securities or a firm has receivables that rely on the sovereign directly or indirectly, then purchasing protection using a CDS is permitted.

ISDA argues that banning naked CDS would have a detrimental effect on individual country’s borrowing costs. An EU study that found that the sovereign CDS market was small relative to the size of underlying bond markets and had negligible effect on credit spreads. Given this evidence, it is puzzling why banning these contracts would somehow affect pricing.

The real issue is that a ban on naked CDS on sovereigns is seen as the “thin end of the wedge”, ushering in greater control on the size of the derivative market, limits on the purposes for which derivatives are used and also on the types of derivative contract permitted. Given the substantial derivative trading profits earned by major dealers, ISDA’s position is predictable.

Historically, CDS contracts were used for hedging. Buyers of protection used these contracts to hedge the risk of default of a firm or country. CDS contracts avoided the need to transfer loans or sell illiquid bonds. It also allowed greater flexibility in hedging and offered ease of documentation. Investors could sell protection to acquire credit exposure, especially advantageous where there was no liquid market in the borrower’s bonds.

Over time, speculative factors came to drive the CDS market. The ability to short sell credit became more important. Buyers of protection, where they did not have any underlying exposure to the issuer, sought to profit from actual default or deterioration in its financial position.

Sellers of protection used CDS contracts for leverage. Selling protection on an issuer required minimal commitment of cash (other than any collateral required by the counterparty). In contrast, purchase of a bond required commitment of the full purchase price.

As trading was not constrained by the physical availability of bonds or loans, the CDS markets were more liquid than comparable bonds, facilitating trading.

The shift from hedging to speculation improved liquidity but at the cost of increased risk. The global financial crisis exposed the complex chains of risk and the inadequate capital resources of many sellers of protection.

ISDA’s argument that a ban on naked sovereign CDS will adversely affect Europe’s financial stability is disingenuous. Speculative trading in sovereign CDS is likely to be more destabilising, allowing potential market manipulation.

In practice, sovereign CDS volumes are low and large traders can influence prices, which frequently affect the values of bonds as well as CDS contracts. Commenting on the problems of AIG’s CDS positions, George Soros accurately stated the true use of these contracts: “People buy [CDS] not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. AIG thought it was selling insurance on bonds and, as such, they consider CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.” [George Soros “One Way to Stop Bear Raids” (23 March 2009) Wall Street Journal].

The response of the industry to the EU proposal reveals that participants are unwilling to admit the unpalatable realities of derivative trading. Much of what passes for financial innovation is a vehicle for unproductive speculative activity, specifically designed to conceal risk or leverage, obfuscate investors and reduce transparency. The aim is to generate profits for dealers.

The EU ban on naked sovereign CDS may be a signal that regulators and legislators now understand the issues and are prepared to address them, bringing about meaningful reform in the control of derivative trading.

By Satyajit Das

Satyajit Das is a former derivative trader, now author of “Extreme Money: The Masters of the Universe and the Cult of Risk” (Forthcoming in Q3 2011) and “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”  (Revised Edition – 2006 and 2010).

Read also Satyajit Das’ 3-part analysis of the European economy and debt crisis:

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Filed under International Econnomic Politics, National Economic Politics, Philosophy

32 responses to “The EU End Game: Regaining Control

  1. Pingback: EU to Greece: New Austerity Package or No Cash | EconoTwist's

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