Aurora Borealis
1 February 2017 CFA Institute Journal Review

The EU Ban on Uncovered Sovereign Credit Default Swaps: Assessing Impacts on Liquidity, Volatility, and Price Discovery (Digest Summary)

  1. Marvin Powell, CFA

Exploring the market impacts of the recent ban on naked credit default swap (CDS) buying within the European Union, the authors consider specifically the ban’s effects on market liquidity, volatility, and price discovery. Although the ban successfully reduced market volatility, it came at the cost of higher bid–ask spreads and increased price delay.

How Is This Research Useful to Practitioners?

The authors find that although the recent ban on naked credit default swap (CDS) buying in the EU contributed to a decline in market liquidity as seen in higher bid–ask spreads, it also successfully stabilized the CDS market as evidenced by the decline in volatility. Moreover, the authors observe the decline in volatility to be more pronounced for the countries deemed riskier. They also find that this short-selling ban negatively affected price informativeness as shown by an increase in price delay, particularly for countries affected by the ban. Furthermore, these pricing issues are more apparent for countries with lower amounts of credit risk.
Market participants should have a thorough understanding of the dynamic relationship between market regulations and their intended, as well as unintended, consequences on market dynamics. Market regulators should use this research to more precisely target and govern markets during financial crises while minimizing unintentional impacts. This research helps such active market participants as portfolio managers better understand that trade execution may become difficult during financial crises should these regulations go into effect. As a result, upfront research and creativity may be necessary to successfully limit a portfolio’s exposure.

How Did the Authors Conduct This Research?

The authors use panel data models to explore the CDS ban’s impact on market liquidity, volatility, and price discovery between 2008 and 2015. They use data from Bloomberg for CDS, benchmark bond yields, and swap rates; data from Thomson Reuters for CDS contracts; and data from the DTCC website for open interest volume. The VIX (Chicago Board Options Exchange Volatility Index) is used as a proxy for market sentiment and risk aversion, and stock market performance is included as a control variable to measure capital constraints in financial institutions. The authors use the spread between repo rates as a proxy for funding costs. They calculate counterparty risk as the average of CDS spreads for the 14 major dealers participating in the CDS market and divide the data sample of CDS contracts on sovereign entities into two groups. Designating one set consisting primarily of EU participants as the treatment group and the other set comprising sovereigns not subject to the ban as the control group, the authors use parametric and nonparametric tests to discover any changes in these two groups. To measure the effect of the ban, they perform a t-test and the Wilcoxon signed rank test. To isolate variables and ensure model robustness, the authors also use dummy variables and regression analysis.

Abstractor’s Viewpoint

The authors provide valuable insight regarding the various market impacts of the ban on naked CDS buying in the EU. To minimize economic disruptions, these findings should inform future regulation and public policy. Although this research does briefly highlight the potential implications for social welfare programs, I would like to see further research identify the social impacts of higher borrowing costs. Specifically, sovereign borrowing rates may deteriorate owing to a reduced level of risk discovery, which would increase borrowing costs and ultimately affect resource allocation decisions and social welfare programs.

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