A paper to be published next month in the Journal of International Money and Finance challenges the widely-held belief that the relatively small credit default swaps (CDS) market cannot influence bond spreads in countries with long-established and large sovereign debt markets, such as France.
By using a radically innovative methodology to study a sample of different European Union member countries during the post-Lehman Brothers’ bankruptcy period, Anne-Laure Delatte of Rouen Business School, Mathieu Gex of the University of Grenoble, and Antonia López-Villavicencio of the University of Paris North, found evidence that the relationship between CDS premiums and bond spreads is not linear. This means that in times of market distress the much smaller CDS market could drive up the bond interest rates of sovereign nations, amplifying the crisis. The study showed that no country is safe from this perverse effect.
While there have been previous studies examining CDS and bond rates, all make the hypothesis that everything happens in exactly the same way no matter what the state of the market. This is the first study that factors in an exception to this unrealistic presumption.
Credit default swaps are a derivative financial product related to an underlying asset, in this case a sovereign bond. The CDS is intended to act as an insurance product allowing buyers to hedge against the default risk of any entity. Normally, the higher the risk of default, the higher the insurance premium – not the other way around.
Yet, counterintuitive findings from this paper reveal that the insurance premium actually influences the risk of default when market uncertainty is high. The higher the insurance premium, the higher the bond rate (i.e. the financing conditions of sovereign states). Based on these findings, the researchers conclude that the CDS are used to speculate against the deteriorating conditions of sovereign states and have a very perverse, self-fulfilling effect.
“This is a scientific argument in favor of a strong regulation of this market,” said Delatte. “Unfortunately the ban on naked CDS (without holding the underlying asset) adopted by the European parliament to be applied in November 2012 isn’t the ideal solution because it can easily be circumvented by market operators.”
Delatte posits that it could also give a false impression of security in a market that is completely opaque.
“Today transactions occur over-the-counter and 80 percent of them happen between five major players,” said Delatte. “This market needs more transparency. For this to occur we must centralize it, establish clearing houses and standardize contracts. This will allow regulators to have a complete vision of what’s really happening in this market, and to intervene if necessary. All of the tax efforts we’re currently making in developed countries to balance the budget are very harmful at the socioeconomic level. This massive effort could be ruined by financial speculation.”
