Ban on naked CDS will backfire, says official Brussels report

THE EUROPEAN Parliament is pushing ahead with plans to ban naked credit default swaps (CDS) – even though its own research has revealed the move would exacerbate market volatility.

European lawmakers are expected to back a German proposal that would ban so-called “naked” CDS, where a trader buys a CDS without holding the sovereign bonds in the expectation that the country will default and the insurance contract will pay out.

The European Parliament and several member states claim that naked CDS have exacerbated the Eurozone crisis by pushing up the bond yields of trouble countries like Greece and Italy.

But new research – commissioned by the European Parliament – reveals a ban could backfire because it would disrupt already volatile markets by reducing liquidity and prompting traders to short sovereign bonds using options and futures contracts instead.

“Prohibiting naked CDS transactions, as proposed, would have detrimental effects on the liquidity… Valuing credit risks will become more difficult,” the German Centre for European Economic Research said in a report commissioned by the European Parliament.