France, Germany seek to curb national debt trading

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The EU, "driven by France and to a lesser extent Germany," will try to restrict the trading of sovereign debt to those who own the underlying bonds, according to diplomats, who say the move is aimed at preventing a repeat of the Greek crisis elsewhere.

Sources close to the EU's policymaking process reveal that current thinking on regulating Credit Default Swap (CDS) trading is limited to sovereign not corporate debt.

Regulation, the sources said, would be restricted to "insurable interest," essentially meaning that only those who own the underlying bond can take out insurance on it.

Credit Default Swaps have been in the political limelight since the Greek debt crisis highlighted that the swaps were hiding the true level of the country's budget deficit and allowing markets to bet on Greece defaulting on its debts.

Sony Kapoor of financial think-tank Re-Define believes the European Commission will likely seek to limit CDS trades to around 100% or 125% of insurable interest.

Zsolt Darvas of Brussels-based think-tank Bruegel says this is a sensible idea as it prevents the market from betting on countries' defaulting on their sovereign debts.

Brussels-based diplomats confirm that France and to a lesser extent Germany are putting their full weight behind imposing restrictions on CDS trading, especially on sovereign debt.

Britain has been unusually quiet in the debate on sovereign debt swaps, as the City of London is a prime sovereign debt-swapping location.

British diplomats say the UK is watching the debate with great interest, but believe it is too early to weigh in with a position on the matter.

EU derivatives rules in progress

The European Commission is in the early stages of drafting a proposal on making derivatives trading – which includes CDS trading – more transparent and pushing all Over The Counter (OTC) derivatives through central clearing houses first.

A proposal had been originally earmarked for July this year but this deadline has since been pushed back.

In 2009 the Commission secured an industry commitment to ensure that a substantial part of CDS are cleared by Central Counterparties (CCPs) – risk managers that proved their worth during the crisis.

Interestingly, this agreement did not include sovereign debt swaps.

According to the Commission, an upcoming review of reporting rules in the Markets in Financial Instruments Directive (MiFID) and Market Abuse Directive (MAD) will include OTC derivatives.

The intention, according to a Commission document, is to enable supervisors and regulators, among others, to monitor the market and find out who holds which positions and which derivatives are systemically important.

EU Internal Market Commissioner Charlie McCreevy opened an investigation into the derivatives sector in October 2008, a month after the collapse of Lehman Brothers, a bank heavily involved in the $600 trillion global derivatives market.

Credit-default swaps are a particular type of credit derivative aimed at guaranteeing a creditor against the risk of default or delays in getting back the credit. Their use was unheard of ten years ago, but the market is now worth hundreds of trillions of euros. 

Credit derivatives typically use benchmarks to value a debit. Once the benchmark is reached, the creditor is paid back a certain amount of the credit, even in the absence of a default.

The advantage of credit derivatives is that they allow companies and governments to increase their means of managing risk. On the other hand, if irresponsibly used, they can increase risk at exponential levels, spreading bad consequences of defaults throughout markets.

Establishing central clearing houses is considered a moderate way of reducing systemic risk related to derivatives. Instead of being exchanged privately ('over the counter'), they could be processed through an intermediary, a move which is expected to improve transparency and reduce risk.

The European Commission clearly supported this approach in a communication published in July 2009 (EURACTIV 06/07/09).

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