Swap crackdown

Momentum is gaining in Europe for greater regulation of derivates trading.

German Chancellor Angela Merkel is the most recent European leader to throw support behind an initiative to curb speculative trading with so-called credit-default swaps (CDS), joining France, Greece and Luxembourg. And she has suggested that Europe could move forward on its own even if the U.S. opposed such action.

European Commission president Jose Manuel Barroso said earlier this month that the Commission would closely examine the possibility of banning purely speculative swap trading.

And European Union finance ministers plan to discuss the proposed ban at a meeting scheduled later this month. The issue is also slated for debate by the Group of 20 nations (G20) in June.

The calls in Europe for greater regulation of derivative trading come as leaders across the region debate whether swaps have contributed to the financial problems that have overwhelmed some countries – notably Greece – or whether they merely reflect them.

Concerns about 'naked bets'

Credit-default swaps are financial instruments that serve as insurance against a bond default. If, for instance, a borrower defaults, the CDS holder is paid by the seller of the protection. Another aspect of this special derivative market is that traders don't need to own bonds to buy protection; instead, they can use the contracts to make what the industry calls “naked bets” on a bond's direction.

Put another way, a naked CDS contract is a bet by an investment company, like a hedge fund, that the bond's issuer will end up in financial trouble.

“There are some issues with credit-default swaps,” said Jan Hagen, a financial expert at the European School of Management and Technology in Berlin. “But they do offer protection and they also give transparency to investors. When CDS spreads increase, there's a good reason to be concerned.”

As debt soars, so does speculation

As the financial problems of Greece and other euro zone countries have escalated in recent months, the prices of swaps insuring against a debt default by those nations have also soared. This development has prompted questions about whether speculation has made the financial woes of these countries even worse.

Numerous politicians believe that hedge funds and other investment companies have been profiting as prices of bonds from Greece and other euro zone countries have plunged.

But there is "no evidence" that credit-default swaps have been used to speculate against Greek national debt, Hagen said, pointing to a study released on Monday by Germany's financial regulator, BaFin. According to the study, the net volume of outstanding credit-default contracts on Greek national debt has remained unchanged since January at approximately $9 billion.

"I think many politicians are just trying to draw attention away from the real problem, which is Greece's debt problem and the growing concerns about the national debt in Spain, Portugal and even the UK," Hagen said.

Investors in two of the world's biggest financial centers, New York and London, are opposed to a ban on credit-default swaps. Last year, U.S. regulators and Congress rejected a proposed ban.

And on Tuesday, Adair Turner, chairman of the UK Financial Services Authority, said naked swaps weren't the "key driver" of the Greek debt crises and advised against rushing to ban them.

Unlikley support from the US

But while an outright ban of credit-default swaps without the support of the U.S. may be unlikely, greater regulation is almost certain, according to Hagen.

"Credit-default swaps aren't traded over exchanges but directly between investment companies, so there is a certain lack of transparency with how they're traded," he said. "Regulators want transparency, and I can imagine that some will argue for credit-default swaps to be traded over some central clearing house in the future."

Author: John Blau
Editor: Rob Turner