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Liquidity Interactions in Credit Markets: An Analysis of The Eurozone Sovereign Debt Crisis

In early 2010, fears of a sovereign debt crisis, the 2010 euro crisis (also known as the Aegean Contagion) developed concerning some European nations, including European Union (EU) members Greece, Spain, and Portugal. This led to a crisis of con fidence as well as the widening of bond yield spreads and risk insurance on CDS between these countries and other EU members, most importantly Germany.

Concern about rising government de cits and debt levels across the globe together with a wave of downgrading of European government debt has created alarm in financial markets. The euro crisis has been mostly centred on recent events in Greece, where there is concern about the rising cost of financing government debt. On May 2, 2010, the Eurozone countries and the International Monetary Fund (IMF) agreed to a 110 billion euro loan for Greece, conditional on the implementation of a package of severe austerity measures. On 9 May 2010, Europe's Finance Ministers approved the creation of the European Financial Stability Facility (EFSF) aimed at preserving nancial stability in Europe by providing financial assistance to eurozone states in economic difficulty.

The objective of the EFSF is to collect funds and provide loans in conjunction with the IMF to cover the nancing needs of euro area Member States in difficulty, subject to strict policy conditionality. Euro area Member States will provide guarantees for EFSF issuance up to a total of 440 billion euro on a pro rata basis.

During the crisis, several commentators expressed concern that the manipulation of the CDS market by speculative investors was playing a signi cant role in exacerbating the liquidity dry up in the market for Greek, Irish, Portuguese and Spanish sovereign debt. In particular,`naked' CDS positions were blamed for driving bond yields on Greek, Irish, Spanish and Portuguese debt higher during the rst half of 2010. In this context, Greece was adjudged to be a victim of short-term speculative short selling practices on its sovereign debt and naked shorting in the CDS market.

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Liquidity Interactions in Credit Markets: An Analysis of The Eurozone Sovereign Debt Crisis