The European debt crisis has raised concerns regarding the use of credit default swaps (CDSs). CDSs are a derivative financial product used to hedge against the default risk of any entity. From the outset, it has been suspected that the crisis has been exacerbated by a few investors driving up the prices in the CDS market. This issue has attracted much interest in policy circles and has led to the adoption of new European regulation, including the ban of naked sovereign CDSs.
There is already some empirical evidence that the CDS market can influence the price of the government bond market when the market is distressed (see Portes on 2012 for a recent contribution, and Delatte et al. 2012). But is this initial scientific evidence enough to justify setting a limit to speculative positions? Essentially, it suggests that CDSs provide a forum for establishing and disseminating price information1. So the question is: Does financial speculation with CDSs play a positive disciplinary role by forcing governments to adjust their fiscal policies? Or have government bond spreads become sensitive to erratic speculative movements? This is still under debate (Duffie 2010 and De Grauwe and Ji 2012).
CDSs have served as a coordinating device for speculation
We address this issue in a recent working paper (Bruneau et al. 2012). A similar question about the disciplinary or destabilising role of financial speculation motivated the development of the ‘second generation’ approach to currency crises in the 1990s2. It describes crises where the economic fundamentals are not the only determinants –a crisis can occur due to market expectations. In our paper, we transpose this approach to analyse the benefits and costs of defaulting for policymakers.
Drawing on Jeanne and Masson (2000), we model the probability of default in the context of the European sovereign crisis. If investors become pessimistic, they sell government bonds. This increases the interest rate and interest-rate payments and thus leads to the burden of public debt. The subsequent austerity efforts increase the probability of default because the government may receive less democratic support to increase taxes. In total, the authorities’ optimal policy may validate market expectations ex post; i.e. default if investors expect a default.
How to bring the theory to the data? How to test the presence of self-fulfilling dynamics during the European crisis? Market expectations matter if, for the same level of fundamentals, investors require a different interest rate. When market participants are optimistic, the interest rate required is low and higher when expectations become pessimistic. The next question is obviously what drives the market sentiment?
To answer, we take a sample of five peripheral European countries in which the sovereign yield has been most under pressure, i.e. Greece, Ireland, Italy, Spain and Portugal. We estimate a relationship between the government spread and the economic fundamentals of these countries (such as the ratio of public debt to GDP, the fiscal deficit, etc…). We then use an innovative estimation method that allows this relationship to be nonlinear., i.e. the relationship changes along observable variables. We test different market signals that may have coordinated the expectations of market participants during the crisis, i.e. financial variables that convey public information, both about the economy as well as the mood of market participants, such as CDS prices and interbank rates.
We find that the markets of sovereign and banking CDSs have played a dominant role in driving market sentiment. In fact, we find that for the same level of fundamentals, investors require a higher interest rate when CDSs premia are high. Within a market environment filled with uncertainty and imperfect information, the CDS market transmits a market signal that leads market participants to believe that other participants “know something”.
The rise in sovereign and banking CDSs premia changes the market’s expectations about the country’s default probability. Market participants sell bonds and banking stocks in the belief that default risk is greater. The market shifts to a pessimistic equilibrium and, in fact, sovereign default becomes more likely. Accounting for shifts in market sentiment explains the sudden eruption of the crisis in countries like Portugal or Spain, where the fundamentals have deteriorated only progressively.
In total we obtain empirical support of an intuition, often heard from market practitioners, that CDS prices affect market sentiment and serve as a coordinating device for speculation. Unfortunately, the regulation on CDSs that has just been adopted by the European Parliament suffers from several limits.
The European regulation on short selling and certain aspects of CDSs
As with most financial derivative products, transactions in the CDS market are traded “over-the-counter” as opposed to on a centralised exchange. A new regulation on short selling and naked CDSs will come into effect across the EU in November 2012. Investors willing to trade sovereign CDSs in an EU country must hold the underlying bond or a portfolio of assets correlated to the value of the sovereign debt3 (a similar ban proposal was debated in the US in 2009 but finally abandoned). The corporate CDSs are excluded from the ban – which is an inconsistency in light of our findings that CDS on banking assets drive market sentiment. The exclusion of banking CDSs clearly introduces a regulatory arbitrage.
More worrying though is an exemption for market makers, which casts serious doubt about the efficiency of the European regulation. In fact, a market participant is considered a market maker when her volume of transactions is sufficiently large and she commits to price any transactions an end-user may ask. In other words, large dealers in CDSs, like JP Morgan for example, are market makers. The point is that this market is highly concentrated, with 87.2% of the CDS trading activity coming from the top 15 dealers (SEC 2012). And the border between market makers and proprietary trading is usually fuzzy in investment banks. In practice, market makers have an overall view of the market, as they know volumes and price better than anyone else. They often reap the benefits of this competitive advantage in order to carry out proprietary trading activity. In sum, there is a realistic risk that the ban excludes market participants – an activity which is precisely the one that the regulation aims to limit.
Effectively, the advantage of this regulation is that it harmonises the regulation on short selling across the EU. Beyond that, its relevance is questionable in the context of the recently implemented European Market Infrastructures Regulation on over-the counter derivatives. Indeed, the regulation aims to increase transparency in the opaque over-the-counter market along similar lines as the Dodd-Franck act in the US. While it covers all over-the-counter derivative markets, it has been inspired by the specific risk associated with CDSs. It introduces reporting and clearing obligations to promote the standardisation of trades. In the case of a highly-concentrated market such as the CDS market, standardisation and clearing reduce opaqueness and avoid collusion. How then can we explain the adoption of a European ban on CDSs in parallel with the European Market Infrastructures Regulation? The answer may be that a ban draws more attention from the general public. Moreover, it illustrates the inconsistencies of the political process in financial regulation.
Bruneau, C., Delatte, AL., Fouquau, J. (2012) "Is the European sovereign crisis self-fulfilling? Empirical evidence about the drivers of market sentiments", Working Paper
Delatte, A.L., Gex, M. Lopez-Villavicencio, A. (2012) “Has the CDS market influenced the borrowing cost of European countries during the sovereign crisis?” Journal of International Money and Finance, Vol. 31, Issue 3, p. 481-497.
Duffie, D. (2010), “CDS on Government Debt”, Hearing before the US House of Representatives, April 29.
Eichengreen, B., C.Wyplosz, (1993) The unstable EMS, Brookings Papers on Economic Activity 1, pp. 51-143.
De Grawe, P., Y. Ji (2012) ”Mispricing of sovereign risk and multiple equilibria in the Eurozone”, CEPS Working Document.
Jeanne O. and P. Masson (2000) “Currency crises, sunspots and Markov-switching regimes”, Journal of International Economics, 50, 327-350
Obstfeld, M. (1996) “Models of currency crises with self-fulfilling features”, European Economic Review 40, 1037–1047.
Securities and Exchange Commission (2012), “Information regarding activities and positions of participants in the single-name credit default swap market” Memorandum, Division of Risk, Strategy and Financial Innovation of the U.S
Porters, Richard (2012), “Credit default swaps: Useful, misleading, dangerous?” VoxEU.org, 30 Apr.
1 As R. Pickel argued before the US House of Representatives in April 2010, “CDS have often been the best way to express a view on credit in troubled times when cash and securities market have seized up”.
2 Eichengreen and Wyplosz (1993), Obstfed (1996) Krugman (1996).
3 Regulators can lift the prohibition temporary in case of market distress which makes the ban semi-permanent.