The Netherlands Authority for the Financial Markets (AFM) has reviewed the role of speculation in the crisis on the European government bond market in response to the Minister of Finance’s request. The Lower House of the Dutch Parliament had asked the Minister for this.
During the second quarter of 2010, there was major turbulence at this market due to Greece’s high government debt and increasing deficits. The AFM has found no indications that market parties have manipulated the bond market. The developments in the market were a reaction to these problems, but not the cause of them.
However, the government bond market is not perfect. Due to the fact that a large part of the transactions of obligations take place outside regulated trading platforms, the transaction prices are only partly transparent. As a result it is not always possible for market participants to make the right prices estimate. CDS prices are sometimes used to determine the price of the related obligation, but do not give the right impression of the underlying asset and the risks at the government bond market.
The market is also only partly transparent for the regulator. The AFM has no insight in the positions and strategies of the market participants. As a consequence the AFM can only interpret and react to market volatility after the event took place.
Finally it is difficult for market participants to judge and mitigate the risks to which they are exposed through the use of CDS and other derivatives. This is a result of the fragmented market infrastructure and the large variety of contracts and cooperations.
According to the AFM it is possible to improve these aspects of the government bond market. The AFM advocates harmonized European regulation and participates in a number of European initiatives. These initiatives aim to improve the pre- and post-trade transparency for investors, the transparency of short positions for the regulator and central trading.
At the same time, the AFM is not in favour of restrictive measures against short selling or the purchase of unhedged Credit Default Swaps. These measures have been identified because they are supposed to mitigate speculation; however, they would more likely cause the pricing to deteriorate and limit the opportunities for the hedging of risks.
These conclusions are contained in the report ‘The government bond market in a European perspective’ [De staatsobligatiemarkt in Europees perspectief], which the AFM published today. The report examines the reasons for the turbulence at the financial markets related to the national debt of some euro countries, and the measures taken to restore stability to the markets.
Greece has had a high national debt and huge deficits for many years. When it appeared that the Greek deficits were higher than expected, market players, in the context of their risk management, started critically examining the increased risks of investments in their portfolios in government bonds from Greece and other EU countries. This change in risk perception led to unrest on the financial markets. The financial measures taken by the EU, the IMF and the ECB have restored the stability of the markets to a certain degree.
Short selling is the selling of securities without owning these securities. Short selling improves market pricing because negative expectations are more rapidly included in the prices. It also enables the market parties to cover the risks of their investments, i.e. hedging. As short selling accelerates pricing, it can reinforce the price fluctuations in the government bond market.
Only Germany announced measures against short selling in response to the national debt crisis. These appear to have resulted in an increase of the market’s unrest.
Credit Default Swaps
Credit Default Swaps (CDSs), comparable with credit insurance, also have a function on the government bond market. Investors can use a CDS to hedge risks, or use it directly in their trading strategy. The prices of these swaps can be used in determining the prices of government bonds, particularly government bonds in which there is limited trading. Only a small number of major players are active on the CDS market, and there is only limited insight into the trading prices. This means that the pricing does not always operate optimally, and the price can sometimes give a distorted picture of the risk of the underlying bond.
Unrest created on government bond market
The AFM believes that the turbulence at the government bond market in 2010 arose from concerns about the creditworthiness of a number of countries in the euro zone. High national debts, weak budgeting discipline and economic recession have led to doubts about the sustainability of government finance in some countries in the euro zone. The AFM has no indication that market parties have manipulated the bond market. The developments in the market were a reaction to the problems, especially in Greece, but were not the cause of the turbulence. The AFM is therefore not in favour of restrictive measures against short selling or the purchase of unhedged Credit Default Swaps.
Conclusions and recommendations
The government bond market is not perfect. Based on the report’s findings, the AFM does a number of recommendations to improve the operation of the government bond market. The AFM is a supporter of harmonized European legislation that aims to improve the transparency and the infrastructure of the government bond market and to strengthen its supervision. For this reason, the AFM participates in a number of European initiatives in the areas identified above. The AFM is calling for the following measures:
The AFM has written this report based on its task of contributing to fair and efficient capital markets. In this context, it examines both the behaviour of participants of these markets and the way that trading takes place. In this review is the AFM therefore not only focuses on market manipulation, but also on the operation of government bond trading as a whole. In addition, this report seeks to provide insight in the functioning of the government bond market and the possibilities for improvement of this market.
The AFM is committed to promoting fair and transparent financial markets.
As an independent market conduct authority, we contribute to a sustainable financial system and prosperity in the Netherlands.