The International Monetary fund said the European Union was moving in the wrong direction by banning the use of a hedging strategy related to sovereign credit default swaps.
In a report published on Thursday ahead of its annual meeting April 19-21, the IMF said the ban on so-called naked SCDS is not supported by any empirical evidence and could in fact lead to more instability in the financial markets.
Credit default swaps act as a kind of insurance for investors who own debt, in this case debt issued by sovereign nations, against potential default or restructuring.
"Overall, the evidence here does not support the need to ban purchases of naked SCDS protection," the IMF said, adding that negative perceptions about the instruments are not backed up by empirical evidence.
An EU rule came into effect Nov. 1 that banned speculative trading in the contracts. A naked contract means the investor does not have an offsetting position in the underlying asset even though they own protection against a rise or fall in the price of the asset.
At the height of the financial crisis, CDS came in for major criticism and were seen as one potential destabilizing factor in the market. The IMF says this is difficult to assess since risks affecting SCDS are the same as those affecting other areas of the financial system.
According to the IMF study, the SCDS market had a net notional value of $3 trillion at the end of June last year, compared with $50 trillion for total government debt outstanding at the end of 2011.
In the CDS market, net notional positions generally represent the maximum possible amount of money that will change hands between those who sold and those who bought credit protection in the event of a default or restructuring.
"The recent European ban on purchasing naked SCDS protection appears to move in the wrong direction. While the effects of the ban are hard to distinguish from the influence of other policy announcements, the prohibition may have already caused some impairment of market liquidity," the IMF said.
The IMF study found the SCDS market and the sovereign debt market are both equally influenced by financial market risk factors.
However, if there is a liquid SCDS market, it will react faster and incorporate information quicker during times of financial market stress relative to the bond markets.
"Overall, SCDS markets do not appear to be particularly more prone to high volatility than other financial markets," the IMF said.
Nor do the price movements in the SCDS market appear to lead to increased costs for sovereigns selling debt in the markets.
The IMF said it was encouraged that the European Securities and Markets Authority will present an investigation to the European Parliament by June 30 on the effects of the regulation.
"In general, the benefits of bans on short positions - to stabilize financial markets, support prices, or contain credit spreads - have not been empirically verified in studies of other bans," the report said.
"Bans on short selling in equity markets are generally viewed as merely reducing market liquidity, hindering price discovery, and increasing price volatility."