EUROPE – Credit default swap (CDS) spreads are a poor proxy for sovereign default risk, according to new research by Imperial College London, and therefore, there is little evidence to suggest the EU-wide ban on naked CDS positions will achieve its aims.
At a recent Peregrine Perspectives discussion series, Lara Cathcart, senior lecturer at Imperial College, presented evidence that trading activity alone did not have a meaningful impact on sovereign default risk, as it does not cause the cost of borrowing for countries to increase.
The increase in CDS spreads during the crisis was mainly due to a surge in liquidity rather than an increase in default risk, she said.
Panellist Paul Crean, co-founder and CIO of emerging market fixed income specialist Finisterre Capital, pointed out that investors often used CDS as liquid tools to hedge their underlying exposures against spread widening, not necessarily out of concerns for a possible default.
Politicians have formulated the EU-wide ban on naked CDS positions based on the belief that a high volume of naked positions can increase the likelihood of default of troubled countries, by increasing their cost of borrowing.
However, Crean cited evidence that the nominal volume of CDS positions alone was not big enough to have a meaningful impact on countries' bond markets.
He said: "CDS spreads are the symptoms – not the cause – of a country getting into trouble. Greece didn't get into trouble because of CDS – it got into trouble because of its spending policy. Investors were desperate to hedge out their risk, and turned to CDS."
He added that banning naked CDS would cause liquidity deterioration for investors trying to hedge their exposures and, as a likely effect, force borrowers into shortening the maturity of their debt.
He also argued that fixed income markets had been a hiding place for investors for the past few years – and that interest rates would normalise and investors need to hedge at some point.
"What is frightening," Crean said, "is that the ban on naked CDS is coming in at the very point investors will need CDS protection more than ever."