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Article

The EU Ban on Uncovered Sovereign Credit Default Swaps: Assessing Impacts on Liquidity, Volatility, and Price Discovery

Paulo Pereira Silva, Carlos Vieira and Isabel Viegas Vieira
The Journal of Derivatives Summer 2016, 23 (4) 74-98; DOI: https://doi.org/10.3905/jod.2016.23.4.074
Paulo Pereira Silva
is a senior financial economist at the Comissão do Mercado de Valores Mobiliários in Lisbon, Portugal.
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  • For correspondence: paulosilva@cmvm.pt
Carlos Vieira
is a professor of economics and a researcher at the Universidade de Évora and CEFAGE in Évora, Portugal.
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  • For correspondence: cvieira@uevora.pt
Isabel Viegas Vieira
is a professor of economics and a researcher at the Universidade de Évora and CEFAGE in Évora, Portugal.
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  • For correspondence: impvv@uevora.pt
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Abstract

During the recent financial crisis, regulatory authorities banned short positions in various financial markets in attempts to moderate pressure from what were felt to be unfavorable, unwarranted, and largely speculative, price changes. Suppression of undesirable price moves was extended to the realm of sovereign debt in November 2012, when the European Union prohibited “naked” purchases of credit default swaps (CDSs) on sovereign bonds. Buying CDS protection is deemed to be naked if the buyer is not doing so to protect an existing long position in the underlying bonds. Academic theory, and empirical evidence from similar bans on short sales in other markets, suggests that such interference in a competitive financial market generally doesn’t work very well: Market participants find ways around the rule; liquidity is reduced in the constrained market; information flow is degraded and prices can become biased because investors with unfavorable beliefs are eliminated from the market; and volatility may increase. Using a “diff-in-diffs” strategy of contrasting the effect on CDS spreads in the 28 affected countries with those in the 56 unconstrained countries as this regulation went into effect, Silva, Vieira, and Vieira show that credit-spread volatility was reduced by the ban, but liquidity was hurt as bid–ask spreads widened and open interest declined. They also find that price informativeness was reduced, in particular by lengthening the time it took for negative information to enter CDS spreads.

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The Journal of Derivatives: 23 (4)
The Journal of Derivatives
Vol. 23, Issue 4
Summer 2016
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The EU Ban on Uncovered Sovereign Credit Default Swaps: Assessing Impacts on Liquidity, Volatility, and Price Discovery
Paulo Pereira Silva, Carlos Vieira, Isabel Viegas Vieira
The Journal of Derivatives May 2016, 23 (4) 74-98; DOI: 10.3905/jod.2016.23.4.074

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The EU Ban on Uncovered Sovereign Credit Default Swaps: Assessing Impacts on Liquidity, Volatility, and Price Discovery
Paulo Pereira Silva, Carlos Vieira, Isabel Viegas Vieira
The Journal of Derivatives May 2016, 23 (4) 74-98; DOI: 10.3905/jod.2016.23.4.074
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