Back in August, we shook our heads as European leaders put a ban on shorting European stocks– and the whole world of futures scrambled to find out just how limited they would be (their market are down about 4.2% since that ban, by the way- though past performance is not necessarily indicative of future results). Now, depending on the final shape of the solution to the Euro Crisis, it looks like they may try another so-called ‘solution’ to keep people from betting against their economies.
The Financial Times reported on the coming resolution on a ban on using sovereign CDS for anything other than hedging this morning:
The most controversial part of the deal will be measures – strongly advocated by Germany – to stop traders buying sovereign CDS as a straight bet rather than as a means of reducing risk exposure on other underlying positions.
While broad agreement has been reached, key details on the size of the exemptions for investors and the rules allowing some national regulators to opt-out of the ban for short periods are still to be resolved in the final round of talks.
The CDS restrictions will be accompanied by a ban on naked short selling of bonds and shares, as well as other rules that will require investors to provide more information on short positions to regulators and the general market.
We tend to believe that such limits rarely accomplish their goals, and as it turns out, the IMF agrees. The FT article continued:
A recent IMF report warned that banning naked sovereign CDS positions “could easily increase contagion rather than diffuse it”.
“The alternatives for counterparties seeking to hedge their sovereign exposures are either rapidly to institute proxy hedges in liquid alternatives (through shorting government bonds, systemic bank equities, or the currency) or to cut country exposure by rapidly reducing credit lines to corporates and banks,” the report said.
Someone from the establishment (we’ll lump the IMF in there with the indebted banks and governments) actually talking about how government intervention can cause unintended consequences? How shocking.
Just as interesting – their theories on what could happen. A spike in short selling of government bonds (and Euro bond futures)? Massive selling of the currency? Managed futures likely wouldn’t mind seeing some of that volume come out of the over the counter CDS market into the exchange traded futures markets (or the currency markets), but would the volume cause trends lower in those? Possibly, but we can’t imagine the hedge and the proxy hedge are that far off in pricing. Sure, a CDS gives direct exposure while shorting the government bonds or currency is indirect exposure, but the market laws of arbitrage would make us believe that if there is a premium available in the proxy over the direct exposure, smart firms will already be using the proxy to earn that premium.
We’ll have to see how the final rules take shape, but as the solution building process drags on, we’re starting to wonder if a workable solution is possible, or if the end game is a rule that requires markets to go only one direction- up.