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Draft EU Regulation Would Deal Ban Naked Credit Default Swaps and Crack Down on Short-Selling and Sovereign Debt Speculation

By Jim Hamilton

The EU Economic and Monetary Affairs Committee approved a draft regulation banning naked credit default swaps and certain trades in sovereign bonds. With regard to shoert selling, the regulation would require traders to settle their uncovered positions by the end of each trading day. Committee members also inserted a requirement that short sale transactions be reported less often, but beefed up the rules to ensure that fines are dissuasive.

Short selling whereby speculators bet on a fall rather than a rise in the price of a security to make a profit, and credit default swaps, which essentially insure against a state defaulting on its debt obligations, were both heavily implicated in Europe's recent sovereign debt crises. The regulation, which must be approved by the European Parliament, takes one more step towards curbing speculation and improving transparency in the financial services sector.

The regulation would ban naked credit default swap trading by prohibiting anyone from being involved in credit default swap transactions if they do not already own sovereign debt linked to that credit default swap, or securities whose price depends heavily on the performance of the country, such as shares in a major company based there. This innovative position not only essentially bans credit default swap naked trading, but also introduces a correlation that would allow investment firms some room for maneuver. .

Although the Committee does not entirely ban naked short selling, it sets a very tight deadline for converting a naked short sale into a short sale. By the end of the trading day, any naked short sales undertaken must have been converted. A seller failing to make the conversion on time would incur fines which must be sufficiently high to prohibit any profits being made.

The position adopted in Committee retains the European Commission's tough locate and reserve rule under which a seller must not only identify from where it plans to borrow the shares in question, but must also have a guarantee that it will indeed be able to borrow them when the time comes.

The Committee imposes further reporting requirements on investment firms, particularly in exceptional circumstances. It also allows national supervisory authorities to require lenders to notify them in exceptional situations. In emergencies, national authorities will be also required to provide more information within 24 hours to the European Securities and Markets Authority (ESMA), when requested.

On the other hand, the Committee position only requires investment firms to report on their short sale transactions at the end of the trading day, rather than reporting each short sale as it happens, as proposed by the Commission. Investors would also be required to publically disclose less information than would have been required by the Commission's original proposal.

Full post as published by Jim Hamilton's World of Securities Regulation on March 08, 2011 (boomark / email).