Treasurers seeking to decide where to issue bonds need to factor in the deleterious effect of the CDS market on economic fundamentals, according to new research. The report, “Watch the indices! Derivatives and the Eurozone sovereign debt crisis,” argues that the spike in sovereign bond yields happened much more rapidly than the fundamental economic deterioration, especially in the periphery.
The authors, Anne-Laure Delatte, Julien Fouquau and Richard Portes, write, “…We know much less about the effects of financial sector CDS on the market’s evaluation of sovereign risk. In a down-cycle, their effect on the cash market may feed back to the sovereign risk.”
The researchers determined that two major synthetic CDS indices facilitated a feedback loop that caused sovereign spreads to spike more rapidly than they would have otherwise. They also noted that the fact that CDS facilitates shorting cash instruments cause their price to fall more rapidly than they would have otherwise – an argument often made by critics of the credit derivatives market.
Corporate debt was affected too. The authors write, “Similarly, standardized CDS contracts on European corporate names were introduced in 2004 when the Europe i-Traxx index was launched. One consequence was that bearish investors had an opportunity to leverage after the market reached a peak, which magnified the depression of financial name prices in the context of the feedback loop between banks and sovereigns.”
This paper conflicts with the conclusions reached by the IMF in its 2010 Financial Stability Report, which held that CDS were not destabilizing. The authors believe the IMF was “looking in the wrong place with inadequate tools.” They write, “Theory exploring the dangerous bank-sovereign loop is supported by our results, in which financial CDS index derivatives appear to play a key role. Sovereign bond investors and regulators should monitor the credit derivative market carefully.” That admonition should apply to Treasurers deciding where to source financing also.