How exactly did the EU “ban” uncovered credit default swaps?

The regulation on the restriction of short selling and trading in credit default swaps, voted on by the European Parliament a month ago, once again demonstrates the chronic inability of European leaders to put into practice their previously stated intentions on a given issue.

The decision in question was declared "key" in the EU's fight to deal with the financial crisis. The European media welcomed the "crusade against speculation", and European leaders began to beat their chests, saying that this decision showed that the EU was determined to deal with the crisis and could be united when the political will was there. Against the background of all the fuss, no one paid much attention to the document itself and the solutions proposed in it, which sound more like: "we don't know what we banned, but maybe we didn't ban it anyway".

It is no coincidence that it took the EU more than a year to reach an agreement on restricting short selling and trading in uncovered credit default swaps. Italy, the UK and Spain have long opposed such a decision, fearing that the new regulation would scare investors and raise their bond yields. As is clear from preliminary impact assessments of the proposed restrictions by the European Commission and other institutions (such as the Centre for European Economic Research, commissioned by the European Parliament), the effects of such regulation are far from one-sided. Ultimately, the resistance of the countries already listed, the conflicting reports and unclear expectations clearly played a role in shaping the final text. Given the decisions taken, “ban” is an unreasonably strong word.

First, there is an option for countries to “temporarily” lift the ban if they consider that bond markets are not functioning “properly”. Some of the factors that allow the ban to be lifted are the “widening of spreads” with other countries’ debt and the “rise in interest rates on the bonds themselves”. Given the current record spreads and the clear trend towards rising interest rates on the debt of a number of countries, almost all European countries can take advantage of this option. And those that cannot, hardly need to do so.

The main objective of the decision is to prohibit the purchase of uncovered credit default swaps against sovereign debt. These are transactions in which the buyer of the swap does not own the debt instrument, but wants to insure himself against the bankruptcy of a given state or to profit from it, hence the speculative element. In return for the payment of certain premiums (i.e. the price of the swap instrument), he can purchase such protection from a counterparty that has agreed to assume the risk of a possible bankruptcy, and in return to receive these premiums. It is this possibility of profiting from someone's insolvency that seems to be the main thorn in the side of regulators. The concern is that in practice there is no limit to how many such swaps can be purchased. In theory, a sufficiently large number of counterparties can purchase protection that even exceeds the total volume of bonds issued by the government.

In the European “ban” on the purchase of such protection, however, an “uncovered” credit default swap is understood to mean something slightly different. According to the agreement, even if the market participant purchasing the credit default swap does not own any government debt, the credit default swap is not treated as “uncovered” if the buyer owns shares in a sector that is “highly dependent on the movement of government bonds.” For example, a shareholder in a Greek bank can buy insurance against the country’s government debt because banks, as holders of a significant amount of government bonds, are highly dependent on the solvency of the country. It is this exception that has led many hedge fund managers to describe the “ban” as difficult to enforce. All of these provisions, of course, do not apply to transactions that have already been concluded.

What will be the effects of the "ban"?

The above exceptions clearly show that the “single ban” is neither entirely single nor exactly a “ban.” If speculators are deprived of the opportunity to buy uncovered credit default swaps against sovereign debt, they may turn to alternative means and methods of hedging risk or seeking profit, such as buying uncovered credit default swaps against corporate debt or currency swaps.

The concerns of European politicians are mainly related to the serious “systemic risk” that could arise from the activation of credit default swaps on European sovereign debt and a possible subsequent chain reaction. The issue that the growth of negative bets against the solvency of European countries is primarily a consequence of their inability to limit their spending will not be addressed in any way. According to an old European tradition, the problems are not treated, but their consequences - an approach that clearly does not work.