EU short-selling ban hits liquidity, hikes uncertainty

Liquidity drained from the sovereign CDS market before the ban took hold this morning – and market-makers are still unsure what they can and cannot do

Credit default swap (CDS) traders say the market is taking the start of the European Union (EU) short-selling ban – which took effect this morning – in its stride so far, thanks to months of preparation. But the position-cutting that occurred during this period has damaged liquidity, and market-makers remain unsure about some of the detail of the new regime.

Under the regulation, market participants are prevented from buying EU sovereign CDSs unless they serve to hedge a long position in that country's debt, or assets or obligations that are highly correlated to it. Further implementing legislation clarified that the level of correlation would be tested both quantitatively – achieving a level greater than 70% over the preceding 12 months – and qualitatively, with market participants required to prove a "meaningful" relationship, using appropriate data.

Subject to certain proportionality criteria, the notional of the underlying and that of the CDS does not need to match exactly, although any mismatch has to be monitored and constantly appraised. More detail is expected from the European Securities and Markets Authority (Esma) in the weeks ahead.

"There are so many questions about how you calculate whether a trade is covered or not. We're still waiting for confirmation from Esma clarifying how you do these calculations," says one London-based source at a large dealer.

Faced with the prospect of being caught with illegal, uncovered positions, the market has erred on the side of caution. In recent months, liquidity in EU sovereign CDSs has collapsed – hitting a net notional of $112 billion by mid-October from a high of $150 billion in August last year, according to analysts at Credit Suisse and JP Morgan. Strategists attribute this partly to a rally in European sovereign credit quality, but also to market participants covering their short positions ahead of the ban – and these new dynamics are expected to persist.

It's almost like you're getting a market-maker exemption but you can't be a market-maker. It is quite astonishing to us

"The technical squeeze we've seen recently is likely to continue after today, given the lack of clarity. This isn't a case of buy-the-rumour-sell-the-fact, where people will come in and put big trades on after it's out of the way. I think we've got a reasonably persistent trend underway," says one strategist at a large European investment bank.

Dealers had been relatively sanguine about the regulation, assuming they would be largely exempt under the terms of Article 17, which provides an exemption for market-making activities. But the wording of Esma's guidance on the topic – which was published as a proposal on September 17 – sparked concern.

The first worry for dealers was that market-making approval could be certified on an instrument-by-instrument basis, forcing them to apply every time a new instrument is issued – and then wait up to 30 days for approval. The Swedish debt office, the Riksgälden, pointed out the folly of this. "Sovereign debt instruments include short-term bills that may have a maturity of just one month when first issued. One could thus not exclude an outcome where market-making is unfeasible over the entire term of the instrument," it said, in a terse response to Esma's consultation.

Dealers engaged in frantic discussions with Esma and the Financial Services Authority (FSA) regarding this point. A temporary understanding emerged whereby each particular equity security needs to be specified, but sovereigns are categorised more widely. That's not quite the activity-based approach dealers were after – allowing a given bank to make markets in all CDSs referencing sovereigns, for example – but it's close enough, dealers say. Two banks confirm they have now received their market-making exemptions and say they have not heard of any dealers being left on the sidelines. But having toiled to get the exemptions, most are still uncertain about what exactly they can do with them.

The problem arises from language in the consultation that places 'anticipatory hedging', and 'arbitrage' outside the bounds of activities allowed under the exemption. With the ban in force, but further detail from Esma not expected until the end of November or early December, dealers complain they have been left to second-guess what they can and can't do.

"You're only allowed to have this exemption for actual market-making activity. Anticipatory hedging is not included. That's likely to be problematic for dealers because, in illiquid markets, that's how they provide liquidity. They try to anticipate future flows and get themselves in a position where they're happy to provide liquidity to others," says Saul Doctor, a credit derivatives strategist at JP Morgan in London.

The Esma consultation also says market-makers should avoid arbitrage activity. Dealers are worried that if they write CDS protection for a client and hedge by shorting the sovereign's bonds, for example, it could be construed as arbitrage. "It's like you're getting a market-maker exemption but you can't be a market-maker. It is quite astonishing to us," says another source at a European investment bank.

Faced with these constraints – and a host of other regulatory pressures – some market participants worry the sovereign CDS market could die off altogether. Michael Hampden-Turner, a credit strategist at Citi in London, believes liquidity will continue to decline slowly, but adds: "We won't really know the full extent of it until the next risk-off phase when spreads rise."

By that time, clients may well have moved on, finding other ways to hedge their exposures or express bearish views on EU sovereign risk, including shorting government bonds – which the regulation does not forbid – or finding single-name proxy CDSs.

"The risk is that if people can't trade the sovereign CDSs, then they'll just go and find a government-guaranteed entity or big corporate within that sovereign to serve as a proxy and hedge there instead," says Doctor at JP Morgan.