Adverse Liquidity Effects of the EU Uncovered Sovereign CDS Ban

On November 1, 2012, the provisions of the EU regulation which bans uncovered short-selling of sovereign (single name) CDS came into effect. Market participants who wish to establish a permitted SCDS position must now hold offsetting risk, such as the underlying sovereign bond. This change raised concerns about the impact on portfolio hedging, the potential for a reduction in SCDS liquidity and the implications of a reduction in the ECB’s bond-buying program. In this report, ISDA examines the liquidity impact of the regulation one year after implementation. Findings reveal that EU-regulated SCDS and sovereign indices experienced sharp volume and trade count declines. Additionally, proxy hedges were found to become less effective due to a correlation breakdown with European SCDS.

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