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German Legislation Bans Naked Short Selling and Naked Credit Derivatives

By Jim Hamilton

German legislation that took effect July 27, 2010 prohibits naked short-selling transactions in shares and certain debt securities as well as naked credit derivatives. The Act on the Prevention of Improper Securities and Derivatives Transactions (Gesetz zur Vorbeugung gegen missbräuchliche Wertpapier und Derivategeschäfte) would exempt from the ban investment services enterprises engaging in such transactions as market makers, lead brokers, or designated sponsors. But, while exempt from the legislative prohibition, the investment services enterprises would still be are required to report these short selling and derivatives activities to BaFin, providing details of all financial instruments concerned. BaFin will soon adopt regulations detailing this reporting requirement. Until then, notifications pursuant to section 30h (2) and section 30j (3) of the Securities Trading Act (Wertpapierhandelsgesetz - WpHG) must be submitted and signed, dated and sent to BaFin by fax.

In addition to information regarding the notifying party, the contact person the position, and the financial instruments concerned must be specified. Further, the financial instruments must be specified in category, such as shares, debt securities and credit derivatives. In the case of shares and debt securities, the date on which the activity in a certain financial instrument is taken up must be stated. In the case of credit derivatives, the respective reference liability must also be specified in addition to the type of the credit derivative and the date on which the activity in a certain financial instrument is taken up. In addition, an electronic version of the list of the financial instruments concerned must be sent to BaFin.

Any changes in the disclosed information must be reported to BaFin at the end of each quarter. Any changes that might occur during the quarter do not need to be reported to BaFin in detail at the time of their occurrence, with a notification of change at the end of the quarter being deemed sufficient. The notification of change must specify on which date the activity has been taken up for a further financial instrument. If no changes have occurred from the previous quarter, a notification of holdings must be submitted.

The recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act, while it placed OTC derivatives under federal regulation, stopped short of an outright ban on naked credit default swaps. A Senate floor amendment to the bill sponsored by Senator Byron Dorgan that would have banned the use of synthetic asset-backed securities and naked credit default swaps in which no one had an insurable interest was tabled and effectively killed.

In light of the prohibitions in the Act on the Prevention of Improper Securities and Derivatives Transactions, BaFin revoked its earlier decrees banning short-selling transactions in certain shares, naked short-selling transactions in debt securities issued by EU Member States whose legal currency is the euro, as well as credit default swaps to the extent that at least one reference liability is a liability of a euro zone country and to the extent that they do not serve as hedging instruments against credit default risks.

However, BaFin noted that earlier FAQs regarding the prohibitory regulations contained in the revoked General Decrees may be used to a large extent when interpreting the provisions of the Act on the Prevention of Improper Securities and Derivatives Transactions. For example, the FAQs define a naked credit default swap as one in which, based on an economic view, a no more than insignificant reduction of the credit risk is achieved for the protection buyer. Also, the ban also applies if such credit default swaps are embedded in other instruments, such as credit-linked notes or total return swaps.

Importantly, the FAQs also indicate that the ban relates only to transactions that have actually been concluded in Germany. The place where the transactions are recorded, however, does not matter. Also, follow-up activities of the concluded transaction, such as the exchange of confirmations, as a rule are not covered. The FAQs also explain that the decree only prohibited transactions in the specified shares that are not backed by securities lending. In other words, only naked short selling transactions are affected. Apparently dovetailing with the legislation, the FAQs state that market makers are not concerned by the ban within the scope of their activities undertaken by contract to perform binding buy and sell orders; and this applies both to stock exchanges and to futures exchanges.

Full post as published by Jim Hamilton's World of Securities Regulation on July 28, 2010 (boomark / email).