Legislation by EU lawmakers that would impose tougher rules on short selling and trading in credit default swaps (CDS) shows doubt among lawmakers about whether their actions are right, according to Andrew Shrimpton, a specialist in tax and compliance matters and member of Kinetic Partners.
Lead Members of the European Parliament (MEPs) on Tuesday agreed legislation on the practices, which have been accused of fuelling market volatility during the financial crisis. The rules, being pushed through by the European Commission, impose greater transparency, increase the powers of EU financial watchdog the European Securities and Markets Authority (ESMA) and ban naked CDS trading (purchasing default insurance contracts without owning the related bonds), making speculation on a countrys default more difficult. CDS trades have been widely blamed for potentially aggravating Greece’s troubles.
However, while not imposing a full ban on naked CDS trading, the lawmakers agreed an exception of an option for a national authority to lift the ban temporarily in cases where its sovereign debt market is no longer functioning properly. The text specifies a limited number of indicators, which could justify the national authoritys action. Moreover, within 24 hours, ESMA would publish an opinion on its website as to the utility of suspending the ban, said Parliament in a statement.
Shrimpton said this exception shows uncertainty among the lawmakers about whether they truly believe CDS trading and short selling are fuelling market volatility to the extent that their rules should be curbed. They [lawmakers] feel naked CDS trading is driving up the cost of debt in Greece but a recent study by the EU found this was not the case. The fact that they have an opt out for states who feel that the absence of naked CDS trading is driving up the cost of sovereign debt and causing more volatility, the opposite outcome of improved stability, makes it look like they not sure whether theyre doing the right thing.
Welcoming the ban, EU MEP Pascal Canfin said: “Today’s compromise will make it impossible for a hedge fund to buy Greek or Italian CDS without already owning the bonds of those countries, for the sole purpose of speculating on the country’s default.”
However, Shrimpton argues that banning short selling can reduce liquidity and have a negative impact on sovereign debt: Banning short selling reduces liquidity and has a negative impact on the sellers who put more pressure on the price as they try sell a stock. A case in point is that of Dexia, which is a Franco-Belgian state bank: when France and Belgium banned short-selling this made stocks less liquid and sellers made Dexias stock sink lower and lower eventually contributing to its collapse. A sobering lesson for France where the outstanding amount of French notional CDSs, went from 14bn to 20bn in the last year which shows investors are keen to hedge French debt more.
Richard Metcalfe, head of global policy and a senior regulatory adviser at the International Swaps and Derivatives Association, also commented on the rules: Given that the crisis was about excessive debt, the measures that stop the market expressing views on that are nothing but a case of shoot the messenger. That doesnt help. Credit derivatives have existed for many entities sovereign and corporate for a long time without any problems. Moreover, CDS are useful for hedging exposures other than bonds. Short selling measures are therefore about hiding from the wider issues and are a way of shooting the messenger.
Under the legislation, short sellers and CDS traders would also be subject to more reporting requirements. By providing extra information to national and European supervisors, the lack of which was one of the main problems for supervisors before the crisis, these authorities will be alerted earlier to potential risk in order carry out their preventative work, said Parliament. For example, supervisors would be informed of large short positions already when this position accounts for 0.5% of the issued capital.
MEPs’ wish that naked short sales would no longer be possible for more than one day was however diluted. The hard “locate and reserve rule”, whereby a trader must not only notify 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, was diluted to requiring the trader to locate and have a “reasonable expectation” of being able to borrow the shares from the located party.
The regulation needs ratification from the European Council and Parliament. A plenary vote in Parliament is expected to be taken in the third week of November. The regulation is expected to enter into force in November 2012.
(JDC)