An Examination of the Impact of the EU Ban on Naked Purchases of Sovereign Credit Default Swaps

Abstract

We examine the impact of the November 2012 EU ban on the naked purchasing of EU
sovereign credit default swaps (CDS). Using a change point model (CPM), we find that
the ban directly reduced trading volumes for single-name CDS on EU sovereign linked
credit. We show that the ban reduced price correlation between CDS and Eurozone
sovereign bonds and we find that the tendency for CDS spread changes to ‘Granger
cause’ bond spread changes dropped after the ban, with bond prices then leading
CDS prices in most core EU countries. Price discovery now occurs in the bond market.
Overall, we see that the EU ban on the naked short selling of EU sovereign CDS
has weakened the relationship between CDS and bond prices, making CDS hedging
less effective. We suggest that a non-functioning CDS market can lead to an increase
in sovereign funding levels