A Signal Loses Its Significance

As a friend recently reminded us, the charts of credit default swaps (CDS) on sovereign debt in the euro area that we are regularly updating in these pages may no longer be indicative of the underlying reality of market perceptions.

This is so because the EU's bureaucrats, in their ongoing attempts to manipulate markets, have issued a ban on so-called 'naked' trading in CDS. This means that speculators are no longer allowed to buy and sell CDS contracts to merely express their opinion. Unless one holds the underlying bonds, one will no longer be allowed to trade these credit instruments from November 1 onward. 

Instead, trading in them now takes place only 'by appointment', as every trade must be sanctioned by the EU's bureaucrats. A buyer or seller of CDS must now be able to “prove that a CDS position is a hedge, showing correlations (both quantitative and qualitative)”.

Not surprisingly, liquidity in the CDS markets is evaporating as a result of these new regulations and we can probably no longer rely on these markets to give us relevant signals (we will however continue to keep an eye on them to see what develops).

 


 

5 year CDS on the sovereign debt of Portugal, Italy, Greece and Spain – with hedge funds no longer able to trade these instruments unless they hold the underlying bonds, liquidity in these markets is drying up and the quality of their price signals comes into doubt. 

 


 

To this it should be noted that the EU's politicians and bureaucrats fundamentally misconceive what the role of speculators in the market economy is. They assume that speculation in financial assets is 'bad' a priori, and that it 'adds no value' to the economy. In the case of CDS contracts on sovereign debt, speculators are painted as evil toads preying on innocent deficit spending governments and interfering with their god-given right to saddle future generations with mountains of debt that can never be repaid.

Similar sentiments are regularly expressed when energy or food prices increase sharply: it is allegedly the 'fault' of speculators in the futures markets that these things happen.

However, this is simply not true. First of all, every entrepreneurial activity is essentially 'speculation'. It matters not whether one buys a stock, a commodity or a CDS contract, or whether one inaugurates a line of production. In all these cases one must make an assessment of future conditions. If this assessment is correct, one will reap a profit, if it is incorrect, one will suffer a loss.

A manufacturer who decides to begin production of a consumer good X today, employing the factors A, B, C and D to do so, must make a correct guess as to the price he can charge for consumer good X at the time the production process is finished and the goods can be shipped and sold. Unless the selling price exceeds what he must pay today for the factors used in their production, he will make a loss. Obviously then, he 'speculates' on a certain configuration of future market conditions.

But what about speculators in financial markets? It is important to keep in mind that the economy is in an unceasing process of trying to move to a state of 'equilibrium' – a state where no further change is possible and essentially all  entrepreneurial profit disappears. However, this state can never be reached – in the real world, the economy is changing without cease, the market data are constantly adapted to changes in people's value scales and perceptions. The role of speculators is to speed up this process of adaptation. By anticipating future changes in market conditions and hence prices, speculators bring these changes about more quickly than would otherwise be the case. This sends important price signals to all other actors in the market economy, who will alter their conduct accordingly. To the extent that speculators err about future conditions, the effects of their actions will be self-correcting. 'Speculative excess' in prices is never sustainable for long, as it will not be supported by the real world supply-demand situation.

Prices are the means by which the economy achieves coordination, they are what makes the market economy work so smoothly in spite of the seeming 'anarchy of production' that has long been bemoaned by socialists and planners as somehow ineffective and wasteful. Given the complexity of the economy and the wide dispersal of knowledge, it is literally impossible for a central planning authority to achieve such coordination. It is the price system that creates what Hayek called the 'spontaneous order' of the market economy. It follows from this that the faster prices are adjusted to changing conditions, the better, as the important information they convey reaches economic actors more quickly.

Speculators in financial markets are therefore indispensable to the smooth functioning of the market economy. Denying them access to trading certain financial instruments as the EU is now doing merely leads to a less efficient economy, as resource allocation becomes sub-optimal.


'Unintended' Consequences

Not surprisingly, the 'unintended consequences' of this policy are already in evidence. For example, the Markit SovX index, which we have regularly updated here, has essentially become useless as a gauge of European credit stress for investors.

As the WSJ recently reported:


“An index once used as a key barometer of Europe’s debt-market stresses is set to be stripped of its remaining relevance as impending new regulation will make it harder to trade.

Trading volumes in the iTraxx SovX Western Europe index — which tracks the cost of insuring against government bond defaults in 14 European countries — have shrunk to zero, building on the collapse witnessed throughout 2012, figures from data provider Markit showed Friday.

New European regulation due to come into force Nov. 1 will ban traders and investors from buying sovereign default-insurance contracts against government debt they don’t own, in turn making it against the rules for investors to purchase the SovX unless they own underlying bonds from each country.

This will further hinder the usefulness of the SovX for investors, who increasingly have found little reason to buy an index representing a basket of countries ranging from those at the center of the debt crisis, such as Spain and Italy, to ones that don’t even use the euro, such as Norway. This is a turnaround from just last year, when the SovX was still viewed as an accurate gauge for the European debt crisis.

[…]

New European Union rules will ban so-called “naked short-selling” of sovereign credit default swaps, or CDS, which pay cash to holders in case of a default. The rules are designed to reduce what is seen as a destabilizing, speculative activity.

It means that unless an investor holds corresponding, positive positions in all 14 countries included in the SovX, buying the index would constitute holding a short position, in breach of the rules.

“If the position is held in sovereign debt of only one or several euro-zone member states, buying SovX to hedge this position would unavoidably lead to acquiring uncovered CDS positions in those sovereigns for which one does not have position in bonds,” said a spokesman at The European Securities and Markets Authority, which oversees the regulation passed by the European Commission.

Markit conducted its semi-annual reshuffle of SovX constituents last week, this time removing less-liquid Cyprus. Since then, the index hasn’t traded at all, data from Markit show.


(emphasis added)

We have put the word 'unintended' in quotes above, because some of these consequences are actually not unintended. The EU's bureaucrats and politicians want to destroy the CDS market, precisely because they do not want investors to have a reliable gauge of sovereign credit stress in the euro area. The idea is that in the absence of a reliable signal, investors will be less inclined to put pressure on the bonds of  governments in fiscal trouble.

This idea is erroneous. The main effect will be to make investors loath to hold such bonds at all, since hedging them has become inefficient – in fact, it has become nigh impossible, given that there are e.g. no longer any trades whatsoever in the SovX (a similar fate likely awaits CDS on the debt of  individual countries). The European government bond markets are based on ever more coercion instead of the free choices of the investing public (we have recently written about how pension funds are forced to buy government debt due to yet another batch of new regulations).

As the WSJ reported in another article on the topic of the CDS trading ban:


“Hedge funds have a significant presence trading CDS in these emerging markets, in what are known as ‘directional trades.’ If they think the economic climate will deteriorate they buy CDS. They sell if they think those economies will do well. And they do it without necessarily owning the underlying bonds.

Some would call this dastardly speculation. But it also keeps the CDS market liquid. And liquid CDS markets help to keep underlying bond markets steady.

Regardless, it will be banned from Nov. 1 for accounts that don’t already hold the bonds. Some market-watchers believe this could discourage investors from buying the bonds. Why buy them if it’s hard to hedge the risks?

Hedging by using indexes won’t work either. The iTraxx CEEMEA index of 17 emerging market countries has done this and worked well in the past. But the index also includes five EU member countries, which are subject to the regulation. Under the “no naked shorts” rule, they will be off-limits for investors who don’t hold all five of the relevant underlying bonds. Unless this index is rejigged, the idea using it for hedging bond exposure is a no-go.”


(emphasis added)

Making it difficult to insure exposure to government debt of course does absolutely nothing to address the underlying problems. It is merely a futile attempt to obscure these problems, by falsely blaming speculators for the results of the irresponsible fiscal policies of European governments.

As far as we are aware the trading ban only concerns CDS contracts on sovereigns, so our bank CDS index will remain relevant. Given the myriad ways in which the fate of governments and banks is intertwined these days, it may therefore serve as a reasonable proxy should trading in sovereign CDS in the EU cease altogether (which unfortunately seems highly likely).

We plan to continue to update the data on sovereign CDS as well for the time being though, unless or until we become convinced that it no longer makes any sense to do so at all. However, we caution readers to henceforth regard these data with the appropriate degree of circumspection.

 


 

Our proprietary unweighted index of 5 year CDS on the senior debt of eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito – white line), compared to 5 year CDS on the senior debt of Goldman Sachs (orange), Morgan Stanley  (red), Citigroup (green) and Credit Suisse (yellow) – these remain relevant.


 


 




Charts by: Bloomberg



 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

One Response to “The EU’s Trading Ban in Sovereign CDS”

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Venezuela – An Economic Catastrophe in Charts
      The Final Stage of a Crack-Up Boom For economists the dire downward spiral of Venezuela's economy holds the same fascination black holes hold for physicists. Both illustrate what happens amid the most extreme conditions imaginable. It is thought that this may potentially provide clues of a more general nature. The remnants of massive imploded stars are inanimate and many light years distant; regardless of how violent conditions in their vicinity are, they cannot touch us. Unfortunately,...
  • The Degrading Facts of a Fake Money Hole in the Head
      Squishy Fact Finding Mission Today we begin with the facts.  But not just the facts; the facts of the facts.  We want to better understand just what it is that is provoking today’s ludicrous world. To clarify, we are not after the cold hard facts; those with no opinions, like the commutative property of addition. Rather, we are after the warm squishy facts; the type of facts that depend on what the meaning of ‘is’ is.   Fact-related pleas... [PT]   The facts,...
  • Thirteen Reckonings Hanging in the Balance
      A Fake Money World The NASDAQ slipped below 8,000 this week. But you can table your reservations.  The record bull market in U.S. stocks is still on. With a little imagination, and the assistance of crude chart projections, DOW 40,000 could be eclipsed by the end of the decade.  Remember, anything and everything’s possible with enough fake money.   Driven by a handful of big cap tech companies, the Nasdaq Composite has made new highs – but the broad market (here shown in...
  • Jayant Bhandari - The US Dollar vs. Other Currencies and Gold
      Maurice Jackson Speaks with Jayant Bhandari About Emerging Market Currencies, the Trade War, US Foreign Policy and More Maurice Jackson of Proven & Probable has recently conducted a new interview with our friend and occasional contributor to this site, Jayant Bhandari, who is inter alia the host of the annual Capitalism and Morality seminar.   Maurice Jackson (left) and Jayant Bhandari (right)   A wide range of topics is discussed, from the strong US dollar and...
  • Gold-Silver Ratio Message - Precious Metals Supply and Demand
      Fundamental Developments Last week the price of gold fell three bucks, and that of silver fell a quarter of a buck. But let us take a look at the supply and demand fundamentals of both metals. Also, we have an interesting development in the gold-silver ratio, a topic we have not addressed in a while. First, here is the chart of the prices of gold and silver.   Gold and silver priced in USD   Next, this is a graph of the gold price measured in silver, otherwise...
  • September – The Most Dangerous Month to Invest
      The Biggest Crashes in History Happened in September and October In the last installment of Seasonal Insights we wrote about the media sector – an industry that typically tends to perform very poorly in the month of August. Upon receiving positive feedback, we decided to build on this topic. This week we are are discussing several international markets that tend to be weak during September and will look at what drives this recurring pattern.   Mark Twain, a renowned...
  • US Equities – Approaching an Inflection Point
      A Lengthy Non-Confirmation As we have frequently pointed out in recent months, since beginning to rise from the lows of the sharp but brief downturn after the late January blow-off high, the US stock market is bereft of uniformity. Instead, an uncommonly lengthy non-confirmation between the the strongest indexes and the broad market has been established. The chart below illustrates the situation – it compares the performance of the DJIA (still no new high since January, although...
  • Honest Work for Dishonest Pay
      Misadventures and Mishaps Over the past decade, in the wake of the 2008-09 debt crisis, the impossible has happened.  The sickness of too much debt has been seemingly cured with massive dosages of even more debt.  This, no doubt, is evidence that there are wonders and miracles above and beyond 24-hour home deliveries of Taco Bell via Door Dash.   The global debtberg: at the end of 2017, it had grown to USD 237 trillion. Obviously this is by now a slightly dated figure, as debt...
  • Gold-Silver Ratio Hits 10-Year High - Precious Metals Supply and Demand
      Fundamental Developments The price of gold dropped five bucks, and that of silver 40 cents last week. But let’s take a look at the supply and demand fundamentals of both metals. Also, we continue to follow the development in the gold-silver ratio.   One can buy a lot of silver for one's gold these days. Silver has become extraordinarily cheap, but keep in mind that it was even cheaper vs. gold in the early 1990s (see the section on silver further below for the details)....
  • Corporate Credit – A Chasm Between Risk Perceptions and Actual Risk
      Shifts in Credit-Land: Repatriation Hurts Small Corporate Borrowers A recent Bloomberg article informs us that US companies with large cash hoards (such as AAPL and ORCL) were sizable players in corporate debt markets, supplying plenty of funds to borrowers in need of US dollars. Ever since US tax cuts have prompted repatriation flows, a “$300 billion-per-year hole” has been left in the market, as Bloomberg puts it. The chart below depicts the situation as of the end of August (not...
  • Dubious Prophecies & Perverse Incentives - Precious Metals Supply and Demand
      Suspect Predictions, Ill Wishes and Worthwhile Targets of Scorn This price of gold fell three bucks, and the price of silver fell ten cents last week. Perhaps because of the ongoing $150 price drop so far since April, we saw some doozy email subjects and article headlines this week.   Panic on the inflation Titanic. [PT]   One notable one, from the man who confidently asserted we will have hyperinflation by the end of the year — in 2009 — now says that the...
  • Gold and Gold Stocks – Small Rays of Light in the Vale of Tears
      A Rebound Gets Underway – Will It Have Legs? Ever since the gold indexes have broken below the shelf of support that has held them aloft since late 2016 (around 165-170 points in the HUI Index), the sector was not much to write home about, to put it mildly. Precious metals stocks will continue to battle the headwinds of institutional tax loss selling until the end of October, to be followed by the not-quite-as-strong headwinds of individual tax loss selling in the final weeks of the...

Support Acting Man

Item Guides

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com