Friday, February 24, 2012

ECOFIN Approves Regulation on Short Selling and Credit Default Swaps

The EU Economic and Financial Affairs Council adopted a Regulation on short selling and credit default swaps that contains common EU disclosure requirements and harmonizes the powers that regulators may use in exceptional situations where there is a serious threat to financial stability. The Regulation covers all types of financial instrument, but given the potential risks posed by short selling, this form of trading is a central element to be governed by the new rules. The Regulation also provides for notification of significant positions in credit default swaps that relate to EU sovereign debt issuers.Having been approved by ECOFIN and the EU Parliament, after publication in the Official Journal, the new Regulation can enter into force before the end of the year.

For significant net short positions in shares of EU listed companies, the Regulation creates a two-tier reporting model. At a lower threshold, positions must be reported privately to regulators so that they can detect and investigate short sales that might constitute abuse or create systemic risks. At a higher threshold, positions must be disclosed to the market in order to provide useful information to other market participants. For sovereign debt, significant net short positions relating to issuers in the EU will always require private disclosure to regulators.

Short selling is a practice whereby investors sell a security that they do not own but whose delivery is promised, with the intention of buying it back later. If the security price drops, the short sellers, after having bought back the securities in question, profit from the price difference. Short selling could roughly be divided into two types: covered short selling, where the seller has borrowed the security, or made arrangements to ensure they can be borrowed before the short sale is done; and uncovered (or naked) short selling, where at the time of the short sale the seller has not borrowed the securities or ensured they can be borrowed.

To mitigate the greater risks created by uncovered short sales, the Regulation provides that anyone entering into a short sale must at the time of the sale have borrowed the instruments, entered into an agreement to borrow them or made other arrangements to ensure they can be borrowed in time to settle the deal. These restrictions do not apply to the short selling of sovereign debt if the transaction serves to hedge a long position in debt instruments of an issuer. Furthermore, if the liquidity of sovereign debt falls below a specified threshold, the restrictions on uncovered short selling may be temporarily suspended by the regulator.

In exceptional situations regulators may temporarily require further transparency or restrict short selling and credit default swap transactions. In such a situation the European Securities and Markets Authority (ESMA) would coordinate action between regulators to ensure that measures are truly necessary and proportionate.

The Regulation will contain highly speculative financial market transactions in government bonds and credit-default swaps. The Parliament fought for very strict conditions for short selling to contain destructive speculation. The new transparency rules will help stabilize financial markets, said Markus Ferber MEP who is responsible for the Regulation on short selling and CDS for the EPP Group.

Short selling of uncovered credit-default swaps for government bonds will be subject to the strictest cirteria. Only if the liquidity in the market for government bonds comes to a standstill will exemptions be possible. Respective applications will have to be endorsed by ESMA. According to Mr. Ferber, this means a de-facto ban on the short selling of uncovered credit default swaps on government bonds. This is crucial as the speculative potential currently possible can lead and has lead to the artificial decrease of the value of certain government bonds, said MEP Ferber.

Credit default swaps can be used as an insurance against the default of government bonds. However, they can also be used to speculate against the value of government bonds. With uncovered credit default swaps, market participants do not possess the financial instruments, they have only borrowed them. Mr. Ferber emphasized that it is logical that CDS on government bonds are meant for investors who actually have the respective government bonds. All else is pure market speculation that can have incalculable effects, he said, and should therefore be contained.

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