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 EUsovereign credit default swaps (CDS). Using a change point model (CPM), we find thatthe ban directly reduced trading volumes for single-name CDS on EU sovereign linkedcredit. We show that the ban reduced price correlation between CDS and Eurozonesovereign bonds and we find that the tendency for CDS spread changes to ‘Grangercause’ bond spread changes dropped after the ban, with bond prices then leadingCDS 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 CDShas weakened the relationship between CDS and bond prices, making CDS hedgingless effective. We suggest that a non-functioning CDS market can lead to an increasein sovereign funding levels