“If you can't use CDS as hedges because they've become illiquid, the temptation is to get rid of sovereign positions altogether,” said Hampden-Turner, a London-based strategist at the U.S. bank. “It will make it more expensive for governments and companies to borrow in the market because people aren't able to have a liquid hedge.”

The impact on government bond prices may be limited by the relative size of the markets, with credit-default swaps covering just 1 percent of French, Italian and German debt, according to data compiled by Bloomberg.

The swaps ban coincides with the Frankfurt-based ECB's pledge to buy bonds issued by euro-region governments, which has also helped reduce demand for sovereign debt swaps and lower insurance costs. The Markit iTraxx SovX Western Europe Index fell to a 2 1/2-year low of 100 on Oct. 25, from about 360 at the start of the year, according to Bloomberg prices.

Less CDS trading and lower prices, combined with ECB- supported bond rates, may remove important early indicators of market stress, said Peter Tchir, the founder of New York-based TF Market Advisors.

“No liquidity and no canaries,” Tchir said. “It's a bad combination.”

Eoin Treacy's view The emergence of the CDS markets as more liquid than the products they purported to cover led to what I refer to as “model myopia”. Investors spent more time dealing in these quasi insurance products than in examining the base instruments. This led to the perverse situation where a move in the former was deemed to correspond to a change in the base instrument regardless of whether this was in fact true. While this worked in theory the practice is highly susceptible to market manipulation.

This was especially evident during the credit crisis when speculators bid up the price of CDS while simultaneously shorting the bonds and equities of the corresponding companies. This practice was akin to insuring your house for double its value then burning it down.

CDS are an innovative product and offer investors the opportunity to hedge default risk which was not previously possible. However just like anything else the tone of regulation must be skewed in favour of capital preservation. A ban on naked trading of CDS is to be welcomed because it should help reduce the market to hedging activity and the risk of a CDS related market dislocation should decline.