(Updates with possible high-frequency trading curbs in fifth paragraph.)
Sept. 2 (Bloomberg) -- Banks and financial firms may face European Union limits on sales of so-called naked credit-default swaps for sovereign debt as part of proposals to prevent the products from exacerbating the region’s debt crisis.
Under the draft plans by the European Commission obtained by Bloomberg News, traders would be banned from exceeding thresholds set by the European Securities and Markets Authority for buying insurance against default on sovereign debt they don’t actually own.
ESMA would “establish for each sovereign issuer a position limit for uncovered positions in credit-default swaps relating to” that country, according to the document prepared for negotiations on an EU short-selling law. National regulators would submit data every six months to help ESMA set the thresholds.
German Finance Minister Wolfgang Schaeuble and lawmakers in the European Parliament have called for the EU to ban naked credit-default swaps on sovereign debt over concerns the securities fueled the euro zone’s debt crisis. Germany already has restrictions on using swaps to bet on sovereign defaults.
The European Union is also discussing related plans to curb high-frequency trading in another attempt to prevent excessive risk taking by traders.
The requirements will include safeguards to prevent high- frequency trades from “overloading” trading systems, generating “erroneous orders” or “otherwise malfunctioning” in a way that would create a disorderly market, according to a separate document obtained by Bloomberg News.
The need for curbs on sovereign CDS has been one of the main dividing lines between the parliament and governments in the 27-nation region in their attempt to agree on an EU short- selling law.
While such a ban was included in the European Parliament’s version of the draft law, Germany has been unable to win enough support from other governments for a similar measure to be included in their version of the text.
“The ability to impose position limits on uncovered sovereign CDS for member states is a major erosion of sovereignty and should only be done if and where individual member states agree,” Syed Kamall, a U.K. lawmaker who represents London in the European Parliament, said in an e- mailed statement.
Policy makers should “stop blaming the problems of Greece, Spain and Italy on ‘speculation’ and short selling,” Kamall said. “Short sellers are merely delivering the bad news that there is little faith in the ability of these countries to tackle their debt problems.”
The document was prepared for a negotiation session between the council and parliament next week. The European Commission, the EU’s executive arm, will also be represented at the meeting, and is responsible for proposing possible compromises.
A spokeswoman at the European Commission couldn’t be immediately reached to comment.
National regulators should be able to temporarily suspend the position limits if they pose a threat to that nation’s ability to sell its bonds, the document says. ESMA should establish thresholds, linked to market liquidity, for when such suspensions should be allowed, the document says.
The commission’s proposal “represents a compromise,” Darren Fox, a financial-services lawyer at Simmons & Simmons LLP in London, said in an e-mail. “It might form the basis of an eventual deal, as both sides are keen for the other aspects of the proposed regulation to become law.”
Traders may be exempted from the position limits if they hold other securities whose value is “directly and immediately impacted” by the government debt, the commission said in a second, related, document seen by Bloomberg News.
If position limits are used as the basis for a deal on the short-selling law “the $64,000 question will be: at what level will ESMA set the thresholds?” Fox said. “Will they be sensible or will they represent a real fetter on investors’ ability to pursue their trading strategies?”
In addition to naked CDS, governments and lawmakers are negotiating on other aspects of the draft short-selling law, including when regulators can introduce emergency curbs.
National regulators should be able to impose bans on short selling of a company’s stock when the share price falls 10 percent or more in one day, the commission said in the second document. This would be in addition to powers for regulators to impose limits when they feel there is a threat to financial stability or market confidence.
Naked Short Selling
Curbs should be placed on so-called naked short selling of stocks by requiring traders to have “located” the shares they need to complete their trades and to have a “reasonable expectation” that they can acquire them, according to a compromise document prepared for next week’s meeting by Poland, which holds the rotating presidency of the EU, and which will represent governments at next week’s meeting.
EU states had previously resisted calls from the European Parliament for traders to have to locate in advance the stocks they intend to sell short. Naked short selling is when traders short shares without ever actually taking possession of them.
--With assistance from: Ben Moshinsky in London. Editors: Anthony Aarons, Christopher Scinta
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