The new set of rules to limit speculators from making Europe’s debt crisis from worsening on government bond defaults are prompting investors to find other alternatives to make sure in fending off from bad profits in the region.
Credit default swaps of CDS on sovereign bonds became a very important instrument at the beginning of the Eurozone crisis. Although some investors used such products to safeguard their holdings of debt, others have utilised them as a means to ‘kill’ should the crisis worsens, which can further weaken market sentiment and push up the cost of borrowing for governments. This led to unsettled authorities and from Nov. 1 European Union rules outlaw the speculative bets citing investors can only purchase a buy sovereign CDS as insurance against a bond they have possession of.
• The short selling ban is devastating CDS liquidity
• Investors are searching for other means of safeguarding and positioning
• Corporate government bonds seen as a possible substitute
In anticipation of the rules –aimed at increasing the transparency and stamping out market manipulation- investors have pulled out the $100 billion market in droves with volumes declining at 40 % from the mid 2011 peaks. As an alternative, they temporarily switch to purchase corporate CDS and selling sovereign bonds or utilising the options market.
Short bets on bonds- when investors sell their bonds that they have loaned, betting the price will decrease so that they can buy them back and reimburse the loan and profit from it. In much simpler terms, a trader cannot simply make any bargain to sell bonds that they have not agreed to borrow, since this increases the risk of a wildly exploratory movement separated from the fundamentals of the underlying asset.
Covering short bets can relatively be done much easier in the repo market for bonds are used as security for loan cash, but are regarded as an expensive means that requires more disclosure than the CDS market.
The value of German sovereign bonds of loan is a hint of short selling levels which has risen to 6 % in the past two months. Although Italy has steadily risen to 7 %, it is not clear on how much of this can be credited to former CDS investors.
Another option is the use of corporate CDS, which are not fully covers by the new set of rules. State-controlled banks are regarded as the best substitute for country risk although they are less fluid and considered as a high risk and more expensive. The net value of corporate bonds safeguards via CDS on the ITRAXX Europe corporate CDS index increased 38 % in the past month as evidenced by studies from the DTCC.
A third probability is to purchase options that give the right to sell bonds, stock or other assets at a much sooner date at a pre-set cost. This is the most precise yet most expensive form of protection but so far Eurex data reveal no increase in interest. There are also a few tell tale signs of traders shifting to non-EU countries whose benchmark SovX Western Europe index is down 58 % earlier this year when the new regulation came into action.
In a last ditch effort to recover the index, it has launched a new ex-EU version from this week’s data says it has not seen the money that fled the Western Europe index appearing elsewhere.