EU Bans Naked CDS

My friend Justin sent me this article

Bloomberg:  Naked Ban Means CDS Safest Relative to Germany:  Poland Credit

"The extra cost of insuring Polish government bonds for five years with default swaps, or CDS, over Germany fell to 45 basis points on Oct. 11, the smallest gap since August 2008, a month before Lehman’s crash deepened the global financial crisis.  The yield on benchmark 10-year notes fell to a seven-year low of 4.46 percent yesterday, according to data compiled by Bloomberg.  European Union regulations will from Nov. 1 ban ownership of sovereign credit-default swaps without holding the underlying debt assets, known as naked long positions, to prevent investors from pushing up insurance costs. Bond holders are lured to Poland by its economic growth, budget discipline and speculation the central bank will lower interest rates. "

Most of the article is about the relative credit-worthiness of Poland.  However the part that I found most interesting is the part about the new EU rule.  Here is a summary of the EU rule

Harvard Law School Forum:   Europe Restricts “Naked” Credit Default Swaps and Short Sales

"On November 15, 2011, the European Parliament adopted a regulation banning any person or legal entity in the European Union (“EU entities”) from entering into “naked,” or uncovered, credit default swaps (“CDS”) on sovereign debt and restricting uncovered short sales on shares and sovereign debt (the “Regulation”) after November 1, 2012. [1] The Regulation also bans such transactions from being effected on any trading venue in the European Union (the “EU”). CDS on sovereign debt that do not hedge exposure to the sovereign debt itself or to assets or liabilities whose value is correlated to the value of the sovereign debt will no longer be permitted.  Short sales of shares and short sales of sovereign debt will be permitted only where the seller has “located” the share or debt instrument prior to entering into the agreement and has a “reasonable expectation” of being able to borrow the shares. The Regulation provides exemptions for market making activities and primary market operations and allows Member States of the EU (“Member States”) to temporarily suspend the ban on uncovered CDS on sovereign debt if the Member State determines that its sovereign debt market is not functioning properly as a result of the ban. The Regulation also introduces reporting requirements for significant net short positions"

So the EU is not banning short sales of sovereign debt - it just requires that you first locate the bond that you intend to short - like we are required to do in the US equity markets.  If the EU did not also restrict holding uncovered CDS then speculators could get around the locate rule by synthetically generating the same exposure in CDS.  So why would the EU want to do this?  From Harvard Law School Forum

"The European Commission (the “Commission”) proposed the ban on uncovered CDS and limitations on uncovered short sales in response to recent market volatility in Euro-denominated sovereign bonds. Member States reacted differently to the market volatility, some taking no action at all. The Commission proposed the Regulation to reduce regulatory arbitrage and compliance costs arising from a fragmented regulatory framework across the EU. While the Commission acknowledges that short sales and CDS have economic benefits, they also note that these transactions present risks to the market that must be controlled. [2]"

An (unspoken) added benefit may be the following:  by banning naked long CDS on sovereign bonds the rule should decrease the demand for CDS protection on such bonds.  Decreasing the demand for CDS protection on sovereign bonds "may" reduce the required insurance premium for these bonds.  Since investors will have to pay less to insure their sovereigns that could reduce the required yield on the bonds (maybe) and help the issuing countries.