Is There a Case for Banning Short Speculation in Sovereign Bond Markets?

Tuesday, May 25, 2010

Economics Working Paper WP10105

Many have raised concerns that speculation, particularly with credit default swap (CDS) contracts, is responsible for raising the borrowing costs of Greece and other issuers of government debt. Others have suggested that CDS speculation is destabilizing. In the United States, significant recent attempts to ban the use of credit default swaps for speculating against the performance of borrowers include a provision in Waxman-Markey Climate Bill as well as the Dorgan amendment to the Senate financial reform bill. In Europe, investigations into the possible damage caused by CDS speculation have been set up by the European Commission and by Michel Barnier, the European Union’s financial services commissioner. In May 2010, BaFin, Germany’s financial regulator, banned speculation in Germany against European sovereign debt, whether through the use of credit default swaps or outright short bond positions. Well known economists, including Joseph Stiglitz and Richard Portes, have argued against allowing speculation with CDS that a borrower will default.

Here, I will explain my view that banning speculation against borrowers, whether through credit default swaps or outright short bond positions, is not an effective approach to financial stability, and would likely result in thinner bond markets and poorer public information about a borrower’s credit quality. This in turn could ultimately raise a borrower’s interest expense. First, though, I offer a quick review of terminology and background data.

Is There a Case for Banning Short Speculation in Sovereign Bond Markets?