IMF Survey : Credit Default Swaps on Government Debt Are Effective Gauge

IMF News, April 11, 2013

Source details

Canonical URL: IMF Survey : Credit Default Swaps on Government Debt Are Effective Gauge

Credit default swaps on government debt are effective tools for investors to hedge risks, and can enhance financial stability, according to a new analysis from the International Monetary Fund.
Publication date: April 11, 2013.
Key judgment: “Sovereign credit default swaps can help investors hedge risk” and are “no more or less effective at representing the credit risk of governments than are the government’s own bonds.” (Laura Kodres)

CDS are financial instruments investors use for hedging and to express an opinion about the creditworthiness of a government, and to protect themselves in the event a country defaults or undertakes a debt restructuring.
The market initially focused on emerging market government debt but has grown rapidly since 2008, especially in advanced economies where sovereign creditworthiness has come under pressure.
Although CDS on government debt are only a fraction of countries’ outstanding debt market, their importance has been growing rapidly since 2008.

CDS spreads and government bond spreads:
- Provide indications of sovereign credit risk that reflect the same economic fundamentals and market conditions as the underlying government bonds.
- Exhibit similar and significant dependence on key economic fundamentals, such as government debt-to-GDP ratios and GDP growth prospects.
- Are similarly influenced by investor appetite for risk and market liquidity.
Information incorporation:
- CDS markets incorporate new information faster than sovereign bond markets during periods of stress, despite wide differences across countries in normal times.
- Generally, the more liquid the CDS market, the more rapidly it incorporates information relative to bond markets.
Potential destabilizing effects:
- The IMF found little evidence to support many negative perceptions that CDS are destabilizing, although there is some evidence that “swap spreads overshoot their predicted level for some euro area countries during periods of stress.”
- Whether CDS markets are more likely to propagate shocks than other markets is unclear because CDS-related risks cannot be readily isolated from systemic financial risks associated with financial firms.

The IMF cautions that measures that hinder the hedging role of sovereign CDS—such as permanent bans on naked selling—could:
- Harm market liquidity and depth.
- Lead hedgers to migrate to other markets, potentially adding stress and volatility to those markets.
- In the longer term, increase sovereign funding costs, contrary to policy intentions.
Recommended policy actions to improve the sovereign CDS market:
- Require counterparties to post initial margin on bilateral trades or move them to a central counterparty clearing house to lessen counterparty risks and reduce the potential for spillovers from sovereign credit events.
- Mandate better data disclosure to mitigate uncertainty about exposures and interconnections of market participants.
- Implement temporary restrictions rather than imposing permanent ones, only if necessary due to stress in financial markets, noting that previous research has found temporary trading bans to be of only limited use.
The IMF also recommends implementing the Group of Twenty regulatory reforms aimed at enhancing the robustness and functioning of over-the-counter derivatives markets.

The European Union has recently banned the purchase of protection using these contracts if the buyer isn’t hedging (naked selling of sovereign CDS contracts).
The IMF will release more research from the Global Financial Stability Report on April 17.

Source: IMF Survey online, April 11, 2013