Regulatory intervention in the European sovereign credit default swap market

The European Short Selling Regulation not only restricts the short selling of shares but (largely in response to the European sovereign debt crisis) also extends its reach into regulating the sovereign debt market. In particular, the Regulation imposes a prohibition on entering into uncovered sovereign credit default swaps (CDSs): a functionally equivalent mechanism to short selling the underlying bonds. This paper provides an overview of sovereign CDSs and their uses and places the concerns voiced about sovereign CDSs in context through an analysis of the relevant economic literature. It then discusses the Regulation’s provisions in the light of these findings. The paper suggests that there are many benefits to using sovereign CDSs and little to support the accusations that developments in the sovereign CDS markets aggravated the sovereign debt crisis. The restrictions may also reduce interest in the underlying bond markets and so may in fact harm the sovereign issuers the provisions were designed to protect.