Berlusconi Is Probably Not Happy With European Regulators' Stance Against Nakedness

Publish date:
Updated on

Europe's multi-faceted plan for saving itself from itself includes not only offering investors CDS on periphery bonds while also preventing CDS on peripheral bonds from paying out on default; it also extends to banning naked CDS on any European government bonds, along with naked shorting of stocks and government bonds. Except nobody exactly knows what "naked" means.

First of all, in common usage (and in the European Parliament's usage), "naked" short selling is shorting without a locate, i.e. without borrowing the shares/bonds. It's a settlement-fail problem. "Naked" CDS buying, on the other hand, doesn't have anything to do with a locate or settlement: it's just buying protection when you don't own the corresponding reference debt. (Or something else, see below.) The two things have nothing to do with each other except the word "naked," or as the EU draft regulations blushingly put it, "uncovered."

If you want to protect settlement systems, you ban shorts without a locate - as the U.S. has kinda-sorta done, for years, with few ill effects. If, however, you want to prevent asset prices from going down, ever, you (might decide to) ban shorts that don't hedge an offsetting long position - which is what the EU proposes to do for CDS but not for physical. The schizophrenia of the rules makes it hard to avoid the conclusion that the EU doesn't know the difference and is just really, really upset by the notion of financial nudity in any form.

But, whatever, at least we know what "naked" means when it comes to CDS, right? Right?

The rules seek to prevent market participants from taking outright short positions in European sovereign debt through CDS, but traders have noted the regulation should provide ample wriggle room for CDS users.

As well as providing an exemption for market-makers, the rules will not consider CDS to be naked if an end-user is seeking to hedge exposure either to the sovereign debt itself or to assets or liabilities “whose value is correlated to the sovereign debt”. ...

“What does this mean in one sentence: if you can show correlation [of greater than zero] then you can buy sovereign CDS,” Shashank Khare, a sovereign CDS trader at HSBC, wrote in a note to clients.

Hmm. But everything is correlated to the sovereign debt. If that guy's right, then you could hedge shares of Fiat, or for that matter of Ford, with Italian government CDS. To be fair the draft rules that I found (from like a year ago) are fractionally stricter, but much is apparently moving around:

For the purposes of this Regulation, a natural or legal person shall be considered to have an uncovered position in a credit default swap relating to an obligation of a Member State or the Union, to the extent that the credit default swap is not serving to hedge against the risk of default of the issuer where the natural or legal person has a long position in the sovereign debt of that issuer or any long position in the debt of an issuer for which the price of its debt has a high correlation with the price of the obligation of a Member State or the Union.

The draft also waves in the direction of allowing regulators to specify "cases in which a credit default swap transaction is considered to be hedging against a default risk ... and the method of calculation of an uncovered position in a credit default swap."

That looks uglier. Best to hope that Mr. Khare is right and that the naked CDS ban - kind of like the naked-short ban - is mostly just a fig leaf, designed to make people feel that a problem has been addressed and Speculators Have Been Punished without actually changing any behavior. Much worse, however, would be the suggestion in the draft rules of imposing a regulatory model of what sorts of correlations are allowed and how positions are allocated between naked and hedging. That would run the risk of making a compliance monstrosity out of what started as a simple, albeit stupid, rule. (Sound familiar?) Replacing a simple principle - here, "never do anything to suggest any concern about whether Silvio Berlusconi is taking this whole debt thing seriously" - with a model-driven approach that would require regulators to judge banks' correlation models and hedging behavior. That sort of approach is always risky even with the best of intentions. With Europe's track record, though, it is a recipe for disaster.

Naked CDS ban may have little impact [IFR]

EU Gets Deal on Naked Sovereign CDS Curbs, Short-Selling Rules [Bloomberg]


JPMorgan's Voldemort Probably Isn't That Magical

John Carney has hilariously convinced a bunch of people that JPMorgan whale-wizard Bruno Iksil could actually be running a synthetic bank on top of JPMorgan's actual bank. The theory, propounded to him by a mysterious trader and sort of supported by an old PIMCO client note, is that Iksil was tasked with hedging JPMorgan's inflation risk and did so by putting on a trade that was (1) long TIPS (for the inflation) + (2) long [write protection on] CDX (for the yield). Now I will tell you a thing, which is that I hedge my inflation risk by being (1) long TIPS (for the inflation) + (2) long MegaMillions tickets (for the yield),* but nobody calls me Voldemort. Here is Doug Braunstein's theory about Iksil: On a conference call with analysts, Braunstein said the positions are meant to hedge investments the bank makes in “very high grade” securities with excess deposits. (J.P. Morgan has some $1.1 trillion in worldwide deposits.) Braunstein said the CIO positions are meant to offset the risk of a “stress-loss” in that credit portfolio. He added the CIO position is made in line with the bank’s overall risk strategy. What can that mean? Presumably the sensible view to take from this is that this is actually part of a "stress-loss" hedge; the CIO is short (bought protection on) a lot of shorter-dated corporate credit and funds it by being long (selling protection on) a lot of longer-dated (5-year) corporate credit, so as to be relatively DV01-neutral but long jump risk. This has the advantage of (1) actually hedging a stress loss in high-grade short-term corporate securities, (2) fitting in with the relative lack of noise in the CIO portfolio,** (3) being what people have told Bloomberg he was doing, and (4) being what JPMorgan has actually said it's actually done in the CIO during the crisis. So it's probably true no? But it's fun to pretend! If you pretend Carney is right you can have one of two views.*** One is Izabella Kaminska's, which is "sure, I guess this is a hedge, but boy is it a mysterious one." You can buy this if you have - as she does - a pretty postmodernist view of what a hedge is. I do too, mostly.