The German regulator's attempt to enhance financial stability by banning 'naked' short selling of shares and sovereign debt, as well as uncovered CDSs, is seen as an unwarranted distraction. Writer Charlie Corbett

What is it?

The German government has passed its Stability Act that temporarily bans uncovered, or 'naked', short selling of all shares and debt securities issued by eurozone countries for trading on domestic exchanges. It has also temporarily banned uncovered credit default swaps (CDSs) where the reference bond and liability are from a eurozone country and do not serve to hedge against default risk.

Who dreamed it up?

The German Federal Financial Supervisory Authority (otherwise known as BaFin). The law came into force in July and will be reviewed in March 2011.

What are the main provisions?

The act bans uncovered short selling of all shares and eurozone government securities traded on a regulated market of a German stock exchange. It also prohibits trading in uncovered CDSs if the reference obligations are eurozone government securities. Added to this is a transparency rule: net short positions in shares listed on a German exchange that exceed 0.2% of all outstanding shares must be reported to BaFin by the end of the next trading day. If the net short position exceeds 0.5% of outstanding shares, the position must also be made public via the Electronic Federal Gazette.

How will it be enforced?

Violation of the short-selling bans could land offenders with a €500,000 fine per violation. However, law firm Morgan Lewis & Bockius says the legislation fails to fully address the consequences of a violation. "In particular, it does not address how the violation would affect a transaction's validity. Under the German Security Trading Act, a violation of a statutory prohibition does not necessarily make the underlying transaction invalid... It remains to be seen which approach the German courts will take with the short-selling prohibitions," says the firm.

What's in the small print?

Market makers who have contractually agreed to buy and sell financial instruments on an ongoing basis on their own account are exempted from the ban if the transaction is required to fulfil such contractual obligations. Transactions concluded by market participants to fulfil a fixed-price transaction with a client are also exempted. Further exemptions can be granted by BaFin at its discretion.

What does the industry say?

The industry is somewhat bemused. No other European country has come up with such draconian measures to tackle financial stability and some suggest that it misses the point. The head of the International Swaps and Derivatives Association, Eraj Shirvani, complains in an article for Bloomberg that "the naked CDS issue is an unwarranted distraction based on misinformation and misperception". The bans could also mean German companies find it harder to hedge economic exposure or to express a view on the creditworthiness of a reference entity.

What do the regulators say?

The working title of the legislation is: "Act aimed at preventing abusive securities and derivatives trading activities" - a strong indication of BaFin's justification. BaFin wants to "enhance the stability of the financial markets and regain investors' confidence in the efficiency of the financial system". The regulator argues that the extreme volatility of late in European debt securities has been driven by "abusive practices" and that a ban on said practices will promote stability. According to BaFin, short-selling and the conclusion of naked credit default risk on eurozone countries led to excessive price shifts, which could have led to major disadvantages for financial markets and threatened the stability of the financial system.

The law of unintended consequences

A month into life under the new legislation, Credit Suisse analyst Mark Buchanan says in a research note: "We find evidence to suggest that the ban may have contributed to reduced liquidity in German financials." The number of shares traded in 10 of the banned stocks fell by a quarter from May 19 to July 26, according to Mr Buchanan, compared with a 2.1% drop in non-restricted German blue-chips. He also suggests the ban may have contributed to increased liquidity in non-German financials as traders sought alternative hedges to long positions.

Could we live without it?

EU regulators have indicated that there are no plans to impose the naked CDS ban more broadly across Europe, which begs the question: Why does Germany therefore need it?



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