Oct. 20 (Bloomberg) -- The European Union’s attempt to ban the use of credit-default swaps to bet against government bonds for any reason other than hedging may be too late to be effective.
“Most buyers of sovereign CDS now are genuine holders of government bond portfolios who are worried about downgrades,” said Georg Grodzki, the London-based head of credit research at Legal & General Investment Management, which oversees about $515 billion of assets. “The damage has been done and has become self perpetuating even without speculative bets.”
Poland, which holds the rotating presidency of the EU, said it reached the accord with lawmakers from the European Parliament at a meeting in Brussels on Oct. 18. The agreement, which still needs the EU’s formal approval, aims to stop traders speculating on the creditworthiness of states while allowing banks and investors to hedge their holdings of government bonds.
German Finance Minister Wolfgang Schaeuble is among European leaders who demanded a ban on so-called naked default- swap trades on government debt, citing concern the practice worsened the euro area’s debt crisis. Speculators use the contracts to benefit as a nation’s creditworthiness declines because the price of the insurance they offer rises as the chances of default mount.
Under the deal announced by the EU presidency, national regulators can suspend the ban if it harms their sovereign debt markets. Only contracts on the bonds of that country will benefit from the exemption, meaning an individual jurisdiction won’t be able to break ranks, said Michael Hampden-Turner, a strategist at Citigroup Inc. in London.
“You wouldn’t be able to get around the ban by using the opt-out,” he said. “Anyway, once you kill off the market it’s very difficult to bring it back to life just like that.”
The U.K. Treasury, which helps oversee the City of London, Europe’s largest financial center, declined to comment on the Polish announcement, because the negotiations haven’t been concluded.
Trading in the contracts may migrate to New York and Hong Kong, where no restrictions are in place, said Citigroup’s Hampden-Turner.
“A lot of business won’t be directly curtailed because clients are outside European jurisdiction,” he said. “A decline in liquidity still remains a threat to the functioning of the market, however.”
Default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements. The contracts can be triggered by a reduction in principal or interest, postponement of payments or a change in the ranking of obligations, according to the International Swaps & Derivatives Association.
The EU’s attempt to ban the use of the contracts for speculation coincides with its efforts to write down Greek debt without triggering the swaps. If successful, it will render banks’ hedges on government debt ineffective without doing anything to resolve the sovereign debt crisis, said New York- based hedge fund manager Peter Tchir.
“Naked short bans are on the way and forced restructuring that doesn’t trigger a credit event is the plan,” Tchir said. “Crushing the sovereign CDS market out of existence does nothing to fix the problems.”
--With assistance from Abigail Moses and Gonzalo Vina in London and Jim Brunsden in Brussels. Editors: Andrew Reierson, Paul Armstrong
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