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CDS, short-selling 'crackdown' could cause significant volatility – experts

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EUROPE - European proposals to "crack down" on short selling and credit default swaps (CDS) are unlikely to affect pension schemes, but they could cause significant volatility in the CDS market, experts have warned.

UK pension schemes and their counterparts in several countries across Europe will probably be unaffected by the proposed "beef up" rules on short selling and CDS trading, as pension schemes have been limited users, they said.

Robert Gardner, co-founder and chief executive at consultancy Redington Partners, told IPE: "The consequences on UK pension schemes will be limited, as they have not used sovereign CDS, and the new measures will more likely impact banks and hedge funds.

"Nonetheless, the implication for pension funds will depend on how this ban impacts the market and how the new regulation fits into their direct holdings or into their holdings in stocks such as bank paper, bank equity or bank debt."

Michel Barnier, EU commissioner for internal market and services, welcomed the proposals, saying they were "a significant step toward greater transparency, stability and responsibility" in short-selling deals and sovereign CDS markets.

But several experts have argued that the measures could have a major impact on the market. One of the main consequences would be a drastic reduction of liquidity in the CDS market, leading to significant volatility of CDS prices.

According to Andrew Shrimpton, member of the financial advisory firm Kinetic Partners, the ban will undermine confidence in member state sovereign bonds and make it more expensive for member states to finance budgets.

"This has been demonstrated by similarly ill-timed regulatory tightening, such as the banning by France, Italy, Belgium and Spain of the short selling of financial stocks earlier this year, which undermined confidence in bank stocks, reduced liquidity in the banking system and eventually led to a taxpayer-funded bailout of Dexia," he said.

Under the new regulation, naked sovereign CDS positions will be prohibited where sovereign CDS are not acquired to hedge an exposure that is correlated to the value of the sovereign debt.

The restriction will not apply to primary dealers and market makers, however.

Ian Marsh, professor of finance at Cass Business School, argued that implementing such a ban actually favoured the banks - which "made the mistakes" in the first place - rather than the speculators who pointed out the problem.

"There are parallels with the short-sales bans briefly introduced in 2008-09," he added. "Then, bank share prices were falling, and regulators banned the selling of shares that the seller didn't actually own. 

"These bans were rapidly reversed in most countries, as they did not help to stabilise bank share prices. Instead, the short-sales bans simply made trading shares by those who did own them less easy and more expensive."

Marsh also expects the ban to have an important effect on costs.

"Excluding by law a whole bunch of buyers of credit insurance will very likely also reduce the supply of insurance," he said.

"Legitimate hedgers will then find it harder to get insurance or to reduce their cover should they judge the situation has improved sufficiently."

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