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On The Unintended Consequences Of Europe's 'Naked CDS' Ban

Tyler Durden's picture





 

We have long warned that the effects of a ban on 'free-market' hedging instruments could well have a negative impact on the underlying market that political leaders are 'trying' to protect (consider the fall in equity prices after the short-sale-bans) and this week brought some clarity with regard Europe's Short-Selling-Regulation (SSR) on CDS. As Citi's Matt King notes: "the technical standards underlying its short selling ban reinforce the view we held previously: the ban seems likely to add to selling pressure on cash bond spreads in peripherals, even if it brings down CDS and tightens the basis." The SSR defines 'naked' as CDS that are 'highly correlated' with long bond positions, and bonds have only tended to be quite correlated to their own CDS at periods of low volatility, but this correlation breaks down over sell-offs, which is precisely when hedging is needed most. This will leave portfolio managers unlikely to want to rely on sovereign CDS hedges (which they may now be forced to unwind at any moment) and presumably means they will be reluctant to take out initial long positions in both peripheral sovereigns and corporates in the first place - reducing demand for cash bonds. Once again - regulators and politicians should be careful what they wish for.

 

Matt King, Citi: As the shorts come off, what will we find underneath?

The European Commission’s publication this week of the technical standards underlying its short selling ban reinforce the view we held previously: the ban seems likely to add to selling pressure on cash bond spreads in peripherals, even if it brings down CDS and tightens the basis.

The latest publication accompanies the SSR (Short Selling Regulation), and defines the methods which will be used to assess net short positions once the regulation comes into force in November. Specifically, it sets out the rules which will be used to establish whether or not they are “naked”, or instead form a permissible hedge.

The SSR will require market participants to net their sovereign shorts with any long positions they hold, either in that same instrument or in other “highly correlated” financial instruments. “Highly correlated” is defined as an 80% correlation over the last 12 months, with an allowance for it to drop below this threshold for a stretch of up to 3 months but remain above 60% for the entire time.

We think these levels are so high that few market participants will be able rely on even genuine hedges being permissible. In peripheral sovereigns, for example, bonds have tended to be quite correlated to their own CDS at periods of low volatility, but this correlation breaks down over sell-offs, which is precisely when hedging is needed most.

During the periods of greatest stress, correlations have dropped below 60% for both Spain and Italy:

 

 

In core countries, hedging will be harder still – correlations are lower and less stable:


 

For those who hope to use sovereign CDS as a macro hedge for longs in corporates, the case is harder still. Here, the correlation must meet the same “meaningful and consistent” requirement over the past 12 months, and will again be monitored on an ongoing basis. Even where correlations have temporarily been above 70%, they have seldom remained there consistently:


 

In sum, we struggle to think that portfolio managers will fancy relying on sovereign CDS hedges which they could be forced to unwind at any moment should correlations drop below 60%. This presumably means they will be reluctant to take out initial long positions in both peripheral sovereigns and corporates in the first place, reducing the likely demand for cash bonds. So while it does look as though many existing shorts through CDS will have to come off, we are not sure policymakers will like what they find underneath.

 


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Sat, 07/07/2012 - 17:17 | Link to Comment PaperBear
PaperBear's picture

Naked anything is counterfeiting, you first have to borrow what you sell.

Sat, 07/07/2012 - 17:19 | Link to Comment Tom Green Swedish
Tom Green Swedish's picture

Isn't this what MF Global did?

Sat, 07/07/2012 - 17:31 | Link to Comment cossack55
cossack55's picture

"careful what they wish for."  Oh, hey, I got a wish for the motherfuckers.

Sat, 07/07/2012 - 17:31 | Link to Comment Nothing To See Here
Nothing To See Here's picture

People keep talking about CDS as if they were worth anything, keep pretending that they are worth anything, and those owning them will end up with anything but something.

Sat, 07/07/2012 - 19:28 | Link to Comment ZeroPower
ZeroPower's picture

The money that is made each quarter selling index CDS, i assure you, they are definitely worth something.

Sun, 07/08/2012 - 09:36 | Link to Comment Nothing To See Here
Nothing To See Here's picture

People pretend that they are worth something, but were they really when Greece defaulted? What when Spain defaults? No trigger am I correct?

Sat, 07/07/2012 - 17:32 | Link to Comment terryfuckwit
terryfuckwit's picture

Yes paper bear I agree naked shorting is surely fraud. tyler please explain??

Sat, 07/07/2012 - 23:47 | Link to Comment FFox
FFox's picture

The "rulers" will not enforce the rules already on the books... thus the master planners have the golden keys... as they naked short the precious metal stocks and have their MSM (main stream media) shills to say over and over how great naked shorting is for their markets.... while legit investors continue to get screwed.... and high speed trading robots continue to feed the coffers of the elites.

Hey... with timmy G still at at the helm (at Treasury), the banksters can continue the well engineered, ongoing collapse, until they have their bellies full of harvested tangible assets (homes, cars, buisnesses, gold, silver, companies, etc.).

Once they've completed their pillage.... the inflation button will be pushed and those same stolen assets will explode in price.... allowing them to continue to fund the political system which brings them their wands of power.

The sad reality is that which ever criminal gets elected president.... the people will continue to get screwed.

Don't hold your breath expecting any serious effort to fight the massive corruption we see everyday in the financial markets.... rules or not, the master planners know the game and own the referees.  SELECTIVE toy fines barely slow them down as they create digital money to fuel the machine.

Some here say the Fed. wants inflation.... not really, as deflation allows them to scoop up assets on the cheap, and pay the sheeple less for their toil.

So it is in the once great USA... now run by globalist criminals.... with little money left for anthing else but ever rising military spending and greed on steroids.

Screw the naked shorts... wherever and whnever they practice their criminal behavior.  Oh, but wait.... we have Gary G at the CFTC to put salve on those wounds... Hahahaha!  What a funny one that is lads!

 

Sat, 07/07/2012 - 18:04 | Link to Comment credittrader
credittrader's picture

<rant>Please don't just instantly 'smash' CDS because that's what you have been indoctrinated to believe is the cause of the current problems. For those who question the sanity of 'naked' CDS - by which I assume you mean a short position without an offsetting long - how many times have you bought puts on a stock you didn't own? How many times have you sold S&P 500 e-mini futures short for a trade? I understand the stigma attached to 'naked shorting' in stocks but CDS are a collateralized/MtM derivative (ask anyone who actually trades them) just like Puts/Calls/Futures when it comes down to it.

It is easy to jump on the bandwagon of hatred for CDS but remember we never had any issues with the Lehman BK - everything settled cleanly; and while Greece was a lucky mess - it settled cleanly.

In general CDS are not held to maturity as default hedges - they are 'traded' for a spread movement (up or down).

JPM's drama is related to a poorly-managed levered CDO tranche (based on CDS) not the CDS itself - AND it is not the CDS that are to blame, it is the hubris of the trader.

Exchange-trade and clear them and most people's arguments go away.

The article's point (and Matt King's) is that if CDS 'hedges' run the risk of being 'force unwound' due to SSR saying that the correlation is not high enough - which occurs at stressed periods, then it will mean managers will be less likely to buy the 'illiquid' bonds in the first place. Remember how important basis traders have been in maintaining any bid in Portuguese (and Spanish bonds) when they have underperformed?

</rant>

Sat, 07/07/2012 - 18:37 | Link to Comment Solarman
Solarman's picture

Excellent analysis.  

Sat, 07/07/2012 - 22:56 | Link to Comment paint it red ca...
paint it red call it hell's picture

And why are they not exchange traded and cleared presently?

Is there something rolled up in the present opaque CDS system that cannot stand the light of day?

Sat, 07/07/2012 - 19:07 | Link to Comment TJ00
TJ00's picture

I'm guessing the longs will go into a new ETF and then they buy CDS on the EFT, so a new layer of fees (looting)  will be created to get around this regulation.

Sat, 07/07/2012 - 19:48 | Link to Comment q99x2
q99x2's picture

Greek FIG leaves anyone.

Sat, 07/07/2012 - 20:14 | Link to Comment Getting Old Sucks
Getting Old Sucks's picture

While I don't know the CDS market other than it's insurance against default, where one entity pledges to cover losses incurred by another if the default occurs, for a recurring fee that fluctuates.  Can anyone really cover the 700 trillion dollars I read about.  Only one to collect in my recollection was Goldman from AIG via the U.S. Taxpayer.  What happens if CDS is outlawed unless the same regulations applied to insurance companies are adhered to?  I know.  Instant bond market collapse.  Maybe we need a few more layers on top.  Doesen't matter, nobody can pay anyway.  Just makes everyone feel better having insurance.  Makes the balance sheet look good too.  Sheesh! 

Sat, 07/07/2012 - 20:30 | Link to Comment bankruptcylawyer
bankruptcylawyer's picture

unregulated insurance products are inevitably subject to fraud, self dealing, insider trading, and ponzinomics----selling more insurance than you could ever pay out the claims for. 

if 2008 isn't proof of this than you're a moron. 

 

that said-----'regulating' cds is retarded. I think all here on zerohedge would agree that more 'regulation' is just more kicking the can status quo . the real choices have to be made to simply allow these banks to all collapse. 

but of course, then the govrnment's collapse. 

this is the mother of all cycles .

 

insurance should be illegal. ALL OF IT. no insurance period not even health insurance. if the govrnement wants to provide fee health services. call it that. don't call it 'insurance'. call it services. 

and i for one support the government providing some public services. it provides for schooling and different schools have local property tax with federal subsidies. public hospitals can and should operate in a similar manner. with private hospitals offering a level of service above and beyond. 

NO insurance. 

 

Sat, 07/07/2012 - 20:36 | Link to Comment slewie the pi-rat
slewie the pi-rat's picture

mr bankster!  take down those shorts!

Sat, 07/07/2012 - 21:59 | Link to Comment Hulk
Hulk's picture

I'd prefer that mrs banker do that...

Sun, 07/08/2012 - 08:30 | Link to Comment hooligan2009
hooligan2009's picture

can anyone tell me why one year LIBOR for banks is lower than the annual premium charged on bank CDS? is borrowing money for a year from a LIBOR contributing bank, the same as shorting it via its 5 year bank CDS 

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