LONDON: New rules to stop speculators making Europe's debt crisis worse by betting on government bond defaults are prompting investors to find alternative ways to insure against or profit from bad news in the region.
Credit default swaps (CDS) on sovereign bonds, a derivatives product offering insurance against a government failing to honour its debt, became very popular at the start of the euro zone debt crisis.
While some investors used them to protect their holdings of debt, others have bought them to make a killing when the crisis deepens, which can further weaken market sentiment and push up the cost of borrowing for governments.
That has unsettled authorities and, from Nov. 1, European Union rules outlaw the speculative bets, saying investors can only buy a sovereign CDS as insurance against a bond they own.
In anticipation of the rules - aimed at increasing transparency and stamping out market manipulation - investors have pulled out of the $100 billion market in droves, with volumes already down about 40 per cent from mid-2011 peaks.
Instead, they are tentatively switching to buying corporate CDS, selling sovereign bonds or using the options market.
"If you've restricted them from using sovereign CDS ... they will clearly look for some alternative that is out there," said Saul Doctor, credit strategist at JPMorgan.
"The most obvious alternative is just to go and short the bonds outright or going short through the futures market."
Short bets on bonds - when investors sell bonds they have borrowed, betting the price will fall so they can buy them back and repay the loan at a profit - also need to be covered.
In other words, an investor cannot make an arrangement to sell bonds they have not yet agreed to borrow, since this runs the risk of wildly speculative movements divorced from the fundamentals of the underlying asset.
Covering short bets can be done relatively easily in the repo market, where bonds are used as collateral to borrow cash, but it is more expensive and requires more disclosure than the CDS market.
The value of German sovereign bonds on loan - an indication of shortselling levels - has risen 6 per cent in the past two months, while for Italy the rise is 7 per cent, according to data from Markit, though it is not clear how much of this can be attributed to former CDS investors.
Volumes are also up in European government bond futures, which can still be shorted.
"People are using government bond futures and have been for a while," said a London-based investor in hedge funds.
indiatimes.com
Credit default swaps (CDS) on sovereign bonds, a derivatives product offering insurance against a government failing to honour its debt, became very popular at the start of the euro zone debt crisis.
While some investors used them to protect their holdings of debt, others have bought them to make a killing when the crisis deepens, which can further weaken market sentiment and push up the cost of borrowing for governments.
That has unsettled authorities and, from Nov. 1, European Union rules outlaw the speculative bets, saying investors can only buy a sovereign CDS as insurance against a bond they own.
In anticipation of the rules - aimed at increasing transparency and stamping out market manipulation - investors have pulled out of the $100 billion market in droves, with volumes already down about 40 per cent from mid-2011 peaks.
Instead, they are tentatively switching to buying corporate CDS, selling sovereign bonds or using the options market.
"If you've restricted them from using sovereign CDS ... they will clearly look for some alternative that is out there," said Saul Doctor, credit strategist at JPMorgan.
"The most obvious alternative is just to go and short the bonds outright or going short through the futures market."
Short bets on bonds - when investors sell bonds they have borrowed, betting the price will fall so they can buy them back and repay the loan at a profit - also need to be covered.
In other words, an investor cannot make an arrangement to sell bonds they have not yet agreed to borrow, since this runs the risk of wildly speculative movements divorced from the fundamentals of the underlying asset.
Covering short bets can be done relatively easily in the repo market, where bonds are used as collateral to borrow cash, but it is more expensive and requires more disclosure than the CDS market.
The value of German sovereign bonds on loan - an indication of shortselling levels - has risen 6 per cent in the past two months, while for Italy the rise is 7 per cent, according to data from Markit, though it is not clear how much of this can be attributed to former CDS investors.
Volumes are also up in European government bond futures, which can still be shorted.
"People are using government bond futures and have been for a while," said a London-based investor in hedge funds.
indiatimes.com
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