Regulation of Short selling
In light of the European debt crisis, the Regulation on Short Selling and CDS (Canfin Report) is a very important piece of legislation in helping to curb speculation in sovereign debts. The essential aspect of this Regulation is a ban of naked credit default swaps (CDS).
While CDS are normally bought as an insurance against losses that may occur on loans, namely on sovereign bonds, it is also possible to buy CDS without owning an underlying security instrument. In the latter case nothing is insured and a gamble is made on a debt default by a country. We then talk about naked (or uncovered) CDS.
Naked CDS is a speculative practice that brings no benefit to the overall economy and creates an incentive to bet on the failure of entire countries. The more the bets the bigger the pressure on the country and, therefore, the danger of default.
Background:
The Commission's proposal to regulate short selling, published in September 2010, is the result of multiple reasons.
In the spring of 2010, Germany and other member states introduced a ban on certain uncovered short sales. These measures were unilateral and un-coordinated and traders could easily circumvent them by trading the same stocks on other stock exchanges or over-the-counter. At the same time, speculation on CDS of sovereign debt increased dramatically which led the Commission to include this in its proposal.
Proposals to address certain aspects of short selling were already included in the Hedge Funds Directive (AIFMD) but they were turned down by the Council because the issue was deemed too complex; a horizontal approach was preferred and the issue left to another, separate, piece of legislation.
S&D achievements:
The S&D Group managed to improve the Regulation along the three following lines which formed the S&D position since the beginning:
- Ban on naked short selling and uncovered positions in CDS: At the end of the trading day the seller needs to have his positions covered. That means that he needs his positions to be located and reserved (the so-called hard locate rule).
In case he fails to do so, we introduced a tough penalties' regime that will apply and that does not allow the seller to make any profit.
- Improve transparency: We broadened the scope of instruments that have to be reported to Competent Authorities. The Regulation now clarifies that not only information about shares but also about other financial instruments relating to shares (derivatives such as options, futures, index-related instruments, contracts for differences and spread bets) need to be notified to competent authorities on a regular basis. This is essential as regulators were powerless to establish a full picture of all trading activities and consequently unable to properly asses potential risks and dangers.
- ESMA's powers are strengthened: The European Securities and Markets Authority (ESMA) can now impose at Union level measures taken by national authorities and establish common guidelines for the implementation of the penalties regime to avoid regulatory arbitrage. ESMA can also conduct on-the-spot inquiries.
Why banning naked CDS (and naked short sales)?
- Naked CDS serve absolutely no social or economic benefit, it is pure speculation.
- Creating instruments that allow the buying and selling of instruments not owned is a phenomenon to be found nowhere in any other part of our economy.
- The only financial "dividend" a CDS delivers is the pay-out of loss compensation that occurs when a country defaults. Being in possession of a CDS without possessing the underlying sovereign debt is pure speculation in favour of a default by a country.
- Those who create and emit CDS, and thus earn money with such financial products, are banks and insurance companies. If they had to pay out the CDS (billions of Euros!!) in case of a default, they would under normal circumstances go bankrupt. Except that, as these financial institutions bear system risks, governments will bail them out anyway.
AK Position on the Proposal for a regulation of the European Parliament and the Council on Short Selling and certain aspects of Credit Default Swaps - COM(2010) 482
The AK basically welcomes the initiatives of the European Commission, which have been pursued on the basis of the G20 decisions to correct the deregulation and liberalisation of
the financial markets, both of which were introduced at the beginning of the eighties of the last century. In combination with other factors, they had significantly contributed to the
vulnerability of the financial markets. Together with an increasingly unbalanceddevelopment within and between
the states, this led to the most serious economic crisis in post-war history. The effort made to make the OTC market
more transparent to enable the supervisory authorities to recognise systemic risks as early as possible, is a first approach. On the one hand, transparency can contribute to more market discipline and is condition for regulation
on the other.