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Credit Default Swaps and Short Selling Written Evidence

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Credit Default Swaps and Short Selling Written Evidence Credit Default Swaps and Short Selling Written evidence Memorandum by Bank of America Merrill Lynch (CDS 1) ................................................................... 1 Memorandum by Mr John Chapman, former Civil Servant and Journalist (CDS 2) ............................ 4 Letter from the Investment Management Association (CDS 3) ........................................................ 10 Letter from the Association for Financial Markets in Europe (AFME), International Securities and Lending Association (ISLA) and International Swaps and Derivatives Association (ISDA) (CDS 4) .... 13 Memorandum by Bank of America Merrill Lynch (CDS 1) 1. How much short selling is there in the sovereign bonds markets? Does this have a significant influence on sovereign bonds? 2. There is no way to measure how much naked short selling occurs in the market. We as market makers and primary dealers in the sovereign bond market are committed to providing bid and offer prices in which counterparties may purchase or sell against us. When accepting a sale trade we have no way of knowing if this takes the client short. From a proprietary perspective we may find ourselves taking a short position but for settlement purposes these are covered by reverse repo after the fact. 3. The ability to trade into a short position is integral to providing liquidity and is a hedging tool to manage risk. 4. What are the risks of naked short sales of sovereign bonds? 5. Naked short selling on the sovereign bond market does not increase risk. Short positions are generally easily covered for settlement as a result of a highly liquid repo market in sovereign bonds. 6. Do credit default swaps (CDSs), both covered and naked, have a significant impact on the price of the underlying sovereign bonds? 7. We do not believe that CDSs have a significant impact on the price of related sovereign bonds. Data available from DTCC (The Depository Trust and Clearing Corporation) shows that sovereign CDS nationals are around 2-3% of applicable outstanding sovereign debt. Such data also shows that there is no correlation between market volume of sovereign CDS and either CDS or bond spreads. It is very hard to believe therefore that CDS significantly impact the price of the related bonds. Rather, the position is the converse. 8. Under what circumstances could CDSs have adverse consequences for the sovereign bond markets? 9. It would not appear that CDS markets of the size and characteristics seen to date have any significant adverse consequences for the sovereign bond markets. 10. Could CDSs contribute to a contagion effect where healthy economies suffer higher borrowing costs? 11. On the contrary, the risk mitigation functions of CDS lead to greater liquidity and a lowering of borrowing costs. 12. Can the use of naked CDSs increase the costs of borrowing? Could naked CDSs contribute to a default by a sovereign government on bonds? 13. As stated above, we consider that the risk mitigation functions of CDS lead to greater liquidity and a lowering of borrowing costs. Whilst it would be theoretically possible for rampant speculation and explosion of the CDS market to have an effect on the cost of borrowing, we have seen no evidence of this in the markets to date. Even if that event happened, it would be a symptom and not the cause of the issue. A sovereign default would be caused by far more serious underlying issues of over borrowing and lack of revenues, the markets would merely be reflecting those underlying concerns. 14. Could EU restrictions on CDSs or naked CDSs have a negative impact on sovereign bond markets across the EU, and on the sovereign cost of borrowing? 15. Yes they could. CDSs are a valuable risk management tool both in respect of a long position in the sovereign debt itself and in respect of exposure to the debt of that state’s banks and corporates. The ability of sovereigns and banks to borrow relies on sufficient investor demand. If investors were prevented from hedging their positions, there would be greater uncertainty involved in holding the debt and fewer investors in the market, leading to lower liquidity and increased borrowing costs. 16. How can the impact of any temporary restrictions or ban on short selling or CDSs be balanced against the benefit which such restrictions could bring in terms of reducing the risk of negative price spirals in distressed markets? 17. We would challenge the assertion that such restrictions reduce the risk of negative price spirals. Rather we would argue that the ability to use CDS to hedge positions could result in investors retaining their exposures. Without the ability to hedge, investors would be inclined to sell, exacerbating the negative price spirals. 18. Could a restriction on CDSs be justified if a country’s cost of borrowing can rise due to CDS price hikes that are unrelated to a country’s credit-worthiness? 19. As stated above, we would contend that CDS pricing is keyed off a country’s cost of borrowing and not vice versa. 20. Should a ban of naked CDSs be introduced at an EU level? Why? 2 21. Evidence does not warrant a ban on short-selling or CDS in circumstances such as those seen in the markets to date. 22. Care needs to be taken to avoid unintended consequences of bans on short selling and CDS. We have a particular concern in relation to the interplay between the Regulation on short selling and the Regulation on OTC derivatives which has the agenda of mandating clearing of suitable derivatives contracts. There is a danger that a move to prevent short selling and naked CDS in relation to sovereign debt may result in a threat to the stability of clearing houses by interfering with their default management process, thereby causing systemic risk. Restrictions would make it more difficult for any other clearing members to bid to take on risk in a clearing house auction process as they would potentially compromise the ability to hedge the resulting portfolio. The margin collected at the clearing house to cover those positions would need to be increased as compared to that taken in circumstances where no restrictions existed. This would lead to higher costs of trading for the industry. 23. Much of the increased activity in sovereign CDS seen at recent times of crisis in the sovereign debt markets can be attributed to hedging activity as sovereigns’ credit deteriorated. This constituted risk mitigation both specifically, in relation to large uncollateralised exposures faced by banks to sovereigns themselves, and generally, in respect of exposures to the relevant country’s corporates and banks. The prevention of naked CDS would prevent this latter, general risk management Preventing general risk management by banks in the financial system arguably increases the instability of the banking system, and does not reduce it. 24. What would be the pros and cons of enabling EU supervisors in certain circumstances, rather than national authorities, to have the power to temporarily restrict or ban short-selling and CDSs in emergency situations? 25. No response 26. Could such a temporary ban of CDSs and short-selling be easily circumvented by market operators? 27. No response 28. General Matters 29. We attach, for your information, a copy of our position paper1 as to the proposed Regulation on Short Selling and Certain Aspects of Credit Default Swaps. 1 For a copy please contact the Clerk of the Sub‐Committee. 3 Memorandum by Mr John Chapman, former Civil Servant and Journalist (CDS 2) 1.1 I welcome this opportunity to comment on the proposed regulation, and to respond to the questions put forward by the Committee. 1.2 The regulation addresses the systemic risks of short selling, as revealed in the biggest financial crisis and economic retreat in living memory. It also provides a necessary defence, as speculators shift their attacks from banks to sovereign bonds. 1.3 But this regulation must only be a first step. The EU Commission must do much more to curb the casino capitalism that has emerged over the last 25 years, looking at:- - the extraordinary growth of short selling, from very low levels in 1995 to 30% or even 40% of stock market activity; - the amoral aspect of widespread gambling against companies or countries; - the domination of short selling by the Reagan-created hedge fund elite, still led by rich individuals; - the unfair trading advantages of hedge funds, notably the ability to short; - the exploitation by hedge funds of traditional investors in a zero-sum situation; - the perverse practice of lending securities to lose value through shorting; - the contempt for quoted companies who may be shorted; - the affront to democracy by the shorting of sovereign bonds by the duo of hedge funds and Wall Street investment banks. - Particular questions raised by the Committee 2.1 The EU Commission has created a defence through notification levels of short holdings of shares or net short positions on sovereign bonds (including CDSs), restraints on naked short selling, exceptional circuit breakers, and actions by individual member states or co- ordinated action by the European Securities Markets Authority (ESMA) in exceptional situations. The Committee has raised the following questions. 2.2 Q1 How much short selling is there in the sovereign bonds markets? Does this have a significant influence on sovereign bonds? What are the risks of naked short sales of sovereign bonds? 2.3 Reports from the New York Times and Reuters indicated short selling of Greek bonds in February this year, and similar action against Irish bonds in November. Data Explorers was the source. Action against Greek bonds was accompanied by purchases of CDSs, which were significant earlier in 2009. The yield on 10 year Greek bonds apparently rose from 5% at end November 2009 to 6.5% in mid-February 2010.
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