The global financial landscape is changing with the emerging realities. Financial activities, once considered normal or hardly noticeable, are coming under greater scrutiny to check increasing instability and restore acceptable standards of behaviour. The decision of the European Parliament on 15th November, 2011 to ban naked credit swaps, an instrument used by traders to bet on the risk of a country failing to pay off debt, was clearly meant to make it impossible to buy credit default swaps (CDS) for the sole purpose of speculating on a country's failure to meet its financial commitments, ordinarily known as default. It may be mentioned that the parliament had finalised the deal last month after long negotiations with the EU governments on banning naked CDS instruments, which were partly blamed for exacerbating Europe's debt crisis. The consensus had emerged that pure market speculation that can have incalculable adverse effects, as in the case of Greece, needs to be contained and new provisions were required to fight the critical issue of debt in the eurozone. Under the rules now adopted by an overwhelming majority, naked CDS instruments would be prohibited in the 27-nation European Union with effect from 1st December, 2011. Notable is the fact that it would be for the first time that Europe would ban a financial product used to speculate on a country's debt. There was also an overwhelming backing for restrictions on the practice of short-selling company stocks from the year 2012 to restrict speculation by traders. The reasons for such an extraordinary decision by the European Parliament are obvious. Debt instruments of countries facing the risk of default do not carry the same intrinsic value in the international financial market and ordinary CDS serves as an insurance against the risk of default for the respective governments, though arguably it is not a very good method to avoid insolvency. Naked CDS go a step further and precipitate an already worsening trend by enabling the investors who do not own the debt to bet on it and allowing them to purchase it later at a cheaper price if a default occurs. Clearly, the European countries have come to realise that CDS on government bonds are only meant for investors who actually have the respective bonds and, therefore, the speculators should not be given a free hand to manipulate the situation because such a practice is bound to drive up pressure on the defaulting countries. There is no doubt in our mind that the ban on naked CDS was based on sound judgement and could serve as a stabilising factor in a crisis situation but it would be difficult to contain some of its side-effects. For instance, if the debt of a country is not priced rightly and its rate not strictly dictated by market conditions, it would be highly difficult for the respective country to borrow money from the international financial market and honour its obligations. It was due to this very reason that some of the countries in the eurozone had earlier opposed such a move. Also, with the stipulated restriction in place, the investors actually owning the debt of a country would find it hard to unload their positions and leave the field in an uncertain market. Besides, the decision would only have a limited impact if countries other than the eurozone do not follow the example set by the European parliament. Obviously, a bigger platform is needed to control unbridled speculation and meet the challenges posed by the debt crisis threatening the world financial order. Finally, it is much more important to halt the accelerating debt crisis by undertaking appropriate measures at an early stage rather than waiting for the crisis to happen and thinking about the remedial policy strategies later on. Copyright Business Recorder, 2011
Comments
Comments are closed.