Will Banning Naked CDS Impact Bond Prices?

We develop a tractable partial equilibrium model to analyze the impact on the bond market generated by a ban on naked credit default swaps. We demonstrate that such a ban will have a negligible impact on the borrowing costs if CDS speculators are risk averse and take positions which are small relatively to the amount of debt outstanding. We find that the ban only excludes from the market moderately pessimistic investors, and induces the most pessimistic to implement their strategy on the short side of the bond market. Despite the sovereign debtor benefits from the reduced yields on the issued bonds, he will suffer from a diminished borrowing capacity after the ban. Such findings suggest that regulators should consider other measures to reduce instability arising from excessive speculation in derivatives markets