Oct. 19 (Bloomberg) -- The European Union reached a deal as part of a short-selling law that will pave the way for an optional ban on naked credit-default swaps on sovereign debt.
Poland, which holds the rotating presidency of the EU, and lawmakers from the European Parliament reached the accord at a meeting in Brussels yesterday.
Under the deal, traders may be prevented from buying CDS on government bonds unless they either own the sovereign debt or other assets whose price moves in tandem with it. Nations will have the right to opt out of the measure if they detect signs that it may affect their borrowing costs.
“These balanced measures will ensure that sovereign CDS are used for the purpose for which they were designed, hedging against the risk of sovereign default, without putting at risk the proper functioning of sovereign-debt markets,” EU Financial Services Commissioner Michel Barnier said in a statement.
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.
Some European governments have also criticized the use of short selling to bet against bank stocks, arguing that the practice has roiled markets. Volatility that sent European bank stocks to two-year lows led France, Spain, Belgium and Italy in August to impose temporary bans on short selling that remain in force.
Under yesterday’s deal, national regulators will be able to suspend the CDS ban in their territory at the first signs that it may harm their sovereign debt market.
The opt out-clause won over some critics of possible bans.
“I never signed up to the belief that a ban on uncovered sovereign CDS would have any positive impact,” Syed Kamall, who represents London in the EU Parliament, said in an e-mailed statement. “However, I’m reassured that member states will have the ability to opt out of the ban, if they see signals that sovereign debt markets are distressed.”
The European Securities and Markets Authority will give a non-binding opinion on whether a national regulators’ decision to drop the ban makes sense. ESMA coordinates the work of national markets regulators in the 27-nation EU.
While the suspensions will in theory be temporary, regulators will be able to renew them indefinitely. Under the terms of the agreement, existing CDS positions will be grandfathered until they expire.
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.
The measure forms part of a broader agreement on an EU law that will also curb naked short selling of stocks and government bonds.
Poland was negotiating on behalf of the EU’s 27 governments, which will now be asked to formally approve the deal. The parliament must also vote on the agreement before it can take effect.
The law was proposed by Barnier in September 2010.
Mary Schapiro, the chairwoman of the U.S. Securities and Exchange Commission, and regulators from the U.K. discussed short selling at a London meeting on Oct. 13.
Located the Shares
Governments and lawmakers agreed 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 will 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.
The agreement would endow ESMA with emergency powers to temporarily ban short selling and trading in CDS in crisis situations.
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.
--Editors: Peter Chapman, Anthony Aarons
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