CDS has amplified European crisis: it’s official!

CrisisThere is now “scientific proof” that credit derivatives have amplified the European debt crisis, a team of researchers said, and has called for more regulation of the market.

They say that failing to make the market more transparent and standardised could lead to financial speculation ruining the massive efforts that developed countries have made to balance their budgets.

Credit default swaps (CDSs) act as insurance against debt issuers defaulting. It should be that the higher the risk of default, the higher the premium on a CDS.

But researchers said this old wisdom is not always true and data proves that these instruments are used for speculation against the deteriorating conditions of sovereign states.

A paper to be published next month in the Journal of International Money and Finance, Anne-Laure Delatte of Rouen Business School, Mathieu Gex of the University of Grenoble, and Antonia López-Villavicencio of the University of Paris North challenge the widely held belief that the relatively small CDS market cannot influence bond spreads in countries with long-established and large sovereign debt markets, such as France.

In times of market distress the much smaller CDS market could drive up the bond interest rates of sovereign nations, amplifying the crisis. The researchers said the study showed that no country is safe from this effect.

Based on their findings, the researchers conclude that CDS are used to speculate against the deteriorating conditions of sovereign states and have a “very perverse, self-fulfilling effect”.

“This is a scientific argument in favor of a strong regulation of this market,” said Delatte.

“Today transactions occur over-the-counter and 80% of them happen between five major players. This market needs more transparency. For this to occur we must centralise it, establish clearing houses and standardise contracts.”

This will allow regulators to have a complete vision of what’s really happening in this market, and to intervene if necessary.

“All of the tax efforts we’re currently making in developed countries to balance the budget are very harmful at the socioeconomic level. This massive effort could be ruined by financial speculation.”

©2012 funds europe