EUROPE – A new report released by the International Monetary Fund (IMF) has recognised the use of credit default swaps (CDS) as an "effective" hedging tool for investors and has urged Brussels to improve the CDS market, rather than banning their use and distorting the market.

In November 2011, the European Parliament voted into law regulation to curb short selling and trading of CDS. The set of rules, which aimed to ban naked CDS trading – the purchase of default insurance contracts without owning the related bonds – was part of Brussels' plan to improve transparency in the CDS market.

Although the European Securities and Markets Authority (ESMA) last year reiterated its intention to exclude pension funds from the new rules – as their activities are not "primarily" related to securities business – other institutions such as hedge funds, investing in CDS contracts for return-seeking purposes on behalf of pension funds, will not be exempt.

However, the IMF's latest Global Financial Stability Report argued that the ban could eventually harm the hedging role of markets, as liquidity and depth deteriorated and resulted in increasing spillovers into to other markets.
This, according to the IMF, could in turn add to financial instability and increase the risk of contagion as hedging investors migrated their hedges into the nearest compatible markets, potentially resulting in unintended stress and volatility to these markets.

In the longer term, such actions could increase sovereign funding costs, contrary to the intentions of policymakers, the IMF also warned.

Laura Kodres chief of the global stability analysis division in the IMF's monetary and capital markets department, said that CDS were receiving a "bad rap".

"They are no more or less effective at representing the credit risk of governments than are the government's own bonds," she added.

The IMF therefore called on Brussels to focus its attention on implementing existing measures instead of banning the purchase of CDS instruments.

One of those measures would be to require counterparties to post initial margin on bilateral derivatives trades or move them to a central clearing house to lessen counterparty risks and reduce the potential for spillovers from sovereign credit events.

The measures, which aim to push as many over-the-counter derivatives into clearing houses as possible, are being implemented under the European Infrastructure Market Regulation (EMIR).

Meanwhile, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) are also in charge of setting up new guidelines for uncleared derivatives transactions.

The IMF finally suggested in its report to mandate better data disclosure to mitigate uncertainty about exposures and interconnections of the market participants, while implement temporary restrictions rather than imposing permanent ones only if necessary due to stress in financial markets.