The EU Adopted a New Regulation on Short Selling and Credit Default Swaps

Ralitsa Kovacheva, February 24, 2012

The Council of EU finance ministers has approved a regulation on short selling and certain aspects of credit default swaps (CDSs). The adoption of the regulation follows an agreement, reached with the European Parliament, which approved it in November last year. The regulation provides for common EU transparency requirements and harmonises the powers of regulators in exceptional circumstances. Namely the powers of the European regulator (the European Securities and Markets Authority, ESMA) were a major concern of the UK. In a letter to the Council the UK and the Czech Republic said they would not support Article 28 of the Regulation, which defines the powers of the European authority to intervene in exceptional circumstances. According to the official press release of the Council, however, only the British delegation abstained from voting.

Why is it important to have a common regulation?

In September 2010 the European Commission presented its proposal for a regulation on short selling. With short selling the seller does not own the bonds, but he is selling them with the intention of buying them back at a later point in time, expecting to profit from the price margin. Even more frapant is the case with the so called naked short selling, when the seller does not even borrow the securities prior to the short sale. Credit default swaps (CDSs) represent a form of insurance against default. It is believed that many have benefited from the debt crisis in the euro area by buying "naked" CDSs - without having any bonds to be insured. This creates incentives investors to speculate against the debt issuer, which increases their profits, but also increases issuer’s risk, the interest rates on his loans and, accordingly, his indebtedness.

As a result of the crisis, European countries have taken various measures to these financial instruments (Germany, for example, banned naked short sales, other countries have imposed temporary restrictions), which necessitates the creation of a common harmonised approach and a mechanism for crisis response. Moreover, measures to restrict or ban short selling have been introduced in third countries like USA and Japan. Following the proposal of the Commission the European Parliament and the Council of Finance Ministers (Ecofin) adopted their positions and began negotiations that ended last fall with a compromise.

Many rules and even more exceptions

According to the regulation investors will be required to disclose their significant net short positions in shares before the regulatory authority when these are more than 0.2% of the issued share capital. And when these reach more than 0.5% of it the information must be disclosed to the market participants. Holders of net short positions on sovereign debt are required to notify regulators. The net short position must be calculated by midnight at the end of the trading day on which a natural or legal person holds the relevant position. The notification or disclosure shall be made no later than at 15:30 on the following trading day.

As to the naked short sales, investors will be obliged in advance to borrow the instruments concerned, enter into an agreement to borrow or have an arrangement with a third party that the lending is secured. The same restrictions apply to the government debt. Traders may enter into CDS transactions "only where that transaction does not lead to an uncovered position in a sovereign credit default swap."

However, as is clear from the position of the European Parliament, it is a sensitive matter, market participants (including member states ) may have various motives and interests so it is not possible to put everything under a common denominator and have unambiguous ban. So there are certain exemptions from the prohibition of "naked" CDSs. In addition, national regulators may suspend the restrictions if they consider that these could increase the cost of borrowing for sovereign issuers or affect the sovereign issuers' ability to issue new debt. A suspension will be valid for an initial period not exceeding 12 months and may be extended by a further period not exceeding six months.

National regulators may impose restrictions on short selling and CDSs in emergency situations when "there are adverse events or developments which constitute a serious threat to financial stability or to market confidence in the Member State concerned or in one or more other Member States", provided that the measure "will not have a detrimental effect on the efficiency of financial markets which is disproportionate to its benefits." The regulators may impose short-term (within days) restrictions on short selling in case of significant fall of the price of financial instruments.

In exceptional circumstances the European regulator may directly prohibit or impose conditions on the entry of natural or legal persons into a short sale. ESMA is empowered to "conduct an inquiry into a particular issue or practise relating to short selling or relating to the use of credit default swaps to assess whether that issue or practise poses any potential threat to financial stability or market confidence in the Union." The European Authority is given a key coordination role with regard to national regulators and is also given the power to take measures where the situation has cross-border implications.

The debt crisis in the euro area