Since the Greek sovereign debt crisis unfolded, many European politicians have accused speculators of using credit default swaps to bet on sovereign default and thereby intensify a debt event. Research – some by the European Commission itself – has shown that this causal relationship does not exist. Yet there is significant support for action.

What is it?

A proposed ban on the use of uncovered credit default swaps (CDSs) on sovereign debt and naked short-selling of securities in Europe.

It is based on the idea that short-selling is open to abuse and can fuel a crisis by leading to a downward spiral in prices. Naked short-selling – selling securities that investors do not own and have not borrowed – is seen by some as pure speculation, and to increase the risk of settlement failure.

Whose idea was it?

It has grown out of the Eurozone crisis and fear about banks' stability.

As Greece's problems spiralled in the first quarter of 2010, many EU politicians accused speculators of deepening the crisis by using CDS to bet on a Greek default. In May 2010, Germany became the first country in Europe to ban naked short-selling in shares of the country’s 10 most important financial institutions.

In June 2010, French president Nicolas Sarkozy and German chancellor Angela Merkel asked European Commission president José Manuel Barroso to consider a total ban on naked short-selling and CDS.

Following a consultation, in September 2010 the commission proposed legislation to regulate short-selling and CDSs. In March 2011, Europe took a step towards a ban when the European Parliament voted to support the proposal.

On March 15, the proposal reached Ecofin, the group of European finance ministers. Consensus could not be reached: French finance minister Christine Lagarde, was strongly in favour; other ministers (including those of the UK, Italy and Spain) were opposed. A decision has now been postponed until the next Ecofin meeting on May 17.

What are the main provisions?

The proposal applies transparency requirements to participants with significant net short positions relating to EU shares and EU sovereign debt, and to significant CDS positions relating to EU sovereign debt issuers. It applies to both exchange and over-the-counter markets.

At a lower threshold (positions that equal 0.2% of the value of the issued share capital of the company concerned, and each 0.1% above that), notification of a position must be made privately to the regulator. At a higher threshold (positions that equal 0.5% of the value of the issued share capital of the company concerned and each 0.1% above that), positions must be disclosed to the market.

Naked short-selling will effectively be banned by a stipulation that, at the time of the sale, firms have borrowed the instruments, entered into an agreement to borrow them, or have an arrangement that ensures that they can be borrowed to ensure that settlement can be carried out.

There are exemptions for market-making activities and for trading in the shares of a company the principal market for whose shares is outside the EU. Any exemptions can be overruled and transparency requirements increased in 'exceptional circumstances', such as periods when there is a 'serious threat' to financial stability or market confidence in a member state or the wider EU. 

What's in the small print?

The proposal also includes a requirement for the 'marking of short orders', which would provide the data that trading venues will be expected to publish daily about volumes of (net) short sales executed on the venue.

Trading venues must also ensure that there are adequate arrangements in place for buy-in of shares or sovereign debt where there is a failure to settle a transaction. In the case of non-settlement, daily fines must be imposed.

What does the industry say?

Unsurprisingly, market participants are seriously worried by the proposals – and by their progress so far.

Sander Schol, a director at the Association for Financial Markets in Europe, says: “Banning naked short-selling is likely to raise the cost of borrowing for EU governments and to impair the ability of companies and pension funds to manage credit risk, while being potentially harmful in managing systemic risk. It will make financial markets less liquid and add uncertainty for European companies looking to hedge risk."

The industry can take solace from the fact that the head of the new European Securities and Markets Authority, Steven Maijoor, is not against shorting, which he believes makes markets more liquid. However, it is unclear how much sway he will have over the shape and scope of the regulation if it progresses.

The law of unintended consequences

While it may be unintended, studies and experience show that the most likely consequence is not unknown. An Oliver Wyman study in 2010, for example, showed that existing public short-selling disclosure requirements reduce equity market liquidity by at least 25%, and cause bid/ask spreads to widen significantly.

Could we live without it?

Most people say yes. In the case of sovereign CDSs, a report about the eurozone sovereign debt crisis produced by the European Commission itself undermines the argument that a limit on CDSs would do anything to protect beleaguered sovereign issuers. It said: “The CDS spreads for the more troubled countries seem to be low relative to the corresponding bond yield spreads, which implies that CDS spreads can hardly be considered to cause high bond yields for these countries.”



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