Bloomberg News

EU Said to Be Close to Deal for Curbs on Naked Sovereign CDS

October 17, 2011

(Updates with comment from EU lawmaker in fifth paragraph.)

Oct. 17 (Bloomberg) -- The European Union is close to an agreement to insert an optional ban on naked credit-default swaps on sovereign debt into a draft law on short selling, under plans to be discussed by government officials and lawmakers tomorrow, according to two people familiar with the talks.

European Parliament lawmakers and officials from the Polish government, which holds the rotating presidency of the EU, are scheduled to discuss such a ban during a two-hour meeting, said the people who couldn’t be identified because the discussions are private. The measure is part of negotiations on a draft EU law that would also curb naked short selling of stocks and government bonds, the people said.

The amount of flexibility that national governments should have to opt out of the rule will be part of the discussions, the people said. The officials and lawmakers will also discuss the terms of an exemption from the ban for traders holding assets whose value is closely linked to that of the sovereign debt.

German Finance Minister Wolfgang Schaeuble and lawmakers in the European Parliament have called for a ban on naked CDS trades on government debt over concerns the practice fueled the euro zone’s debt crisis. Germany already has restrictions on using swaps to bet on sovereign defaults.

“It’s vital” that any agreement doesn’t undermine investors’ ability to use sovereign CDS to hedge risks on assets such as bank securities whose prices move in tandem with those for government bonds, Syed Kamall, a U.K. lawmaker who represents London in the European Parliament, said in an e-mail.

“Knock-on Effects”

Undermining this so-called proxy hedging “could make some countries less attractive for investors,” Kamall said. “A definition that is too restrictive could have serious knock-on effects such as reducing market liquidity and potentially pushing up borrowing costs for unstable sovereign debt markets.”

CDS are instruments that act as insurance for the buyer against losses on bonds. The practice becomes naked when someone buys swaps on debt that they do not actually own.

Governments and lawmakers have already agreed during previous rounds of negotiations that curbs should be placed on naked short selling of stocks by requiring traders to have at least located the shares they need to complete their trades and to have a reasonable expectation that they can acquire them.

For naked short-selling of sovereign debt, only a reasonable expectation would be required, with governments able to temporarily suspend even this rule if it poses a threat to the nation’s ability to sell its bonds.

Short sellers sell borrowed shares with plans to buy them back later at a lower price, a practice politicians and some investors blame for roiling markets.

Naked short-selling is when traders short shares without ever actually taking possession of them.

Mary Schapiro, the chairwoman of the U.S. Securities and Exchange Commission, and regulators from the U.S., Europe and Asia discussed short selling at a London meeting on Oct. 14.

--Editors: Peter Chapman, Jones Hayden

To contact the reporters on this story: Jim Brunsden in Brussels at jbrunsden@bloomberg.net;

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net


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