Abstract

I document how a series of bans on naked credit default swap (CDS) purchases affected the market for the underlying bonds. A CDS purchase is referred to as naked when the CDS buyer does not own the underlying bond. Such purchases are a way to short the underlying bonds. Using a difference-in-difference analysis, I show that when Germany temporarily banned naked CDS purchases in May 2010, liquidity and price of the affected bonds improved. However, when the European Union (EU) permanently banned naked CDS purchases later in November 2011, liquidity and price of the underlying bonds deteriorated instead. Thus, temporary versus permanent bans had opposite effects on the underlying bond market. This finding challenges policymakers, who tend to design long-term regulations based on the outcomes of short-term regulations (e.g., pilot studies). It shows that the effect of a permanent policy cannot be extrapolated from a short-term one.