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
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.
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