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EU agree regulations on short selling

Out-Law News | 19 Oct 2011 | 5:10 pm | 3 min. read

The European Parliament and Council of Ministers have backed proposals to generally prohibit the practice of 'naked short selling' of Government debt, the European Commission has said.

Investors 'short sell' when they sell assets, such as shares, hoping that the price will fall and then buy back the assets at a cheaper price in order to pocket the difference. Short selling is 'covered' when the seller has borrowed the assets to sell, but is 'naked' when they have not.

The Commission, Parliament and Council have agreed a draft of new regulations that would generally ban traders naked short selling on sovereign debt but enable member states to lift the restriction if it threatens the flow of money in the market. The ban would not apply to "market makers and primary dealers", the Commission said.

"In order to enter a short sale an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party under which that third party has confirmed that the share has been located or has otherwise reasonable expectation that settlement can be effected when it is due," the European Commission said in a statement.

"The restrictions do not apply if the transaction serves to hedge a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the given sovereign debt," it said. "In addition, the competent authority may temporarily (for 6 months, renewable) suspend these restrictions where the liquidity of the sovereign debt falls below a pre-determined threshold, to be set by the Commission in a delegated act."

"[The European Securities Market Authority (ESMA)] shall develop draft implementing technical standards to determine the types of agreements, arrangements and measures that adequately ensure that the sovereign debt will be available for settlement," it said.

The agreed new regulations, which also include a general ban on the naked short selling of shares, have been introduced "in order to reduce the risks of settlement failures and increased price volatility," the Commission said. The regulations ensure that financial service regulators across the EU "have all the powers necessary" to enforce the new rules, it said.

The agreed proposals also include a general ban on naked Government 'credit default swaps' (CDS), which is said can also be used by traders to "secure a position economically equivalent to a short position in the underlying bonds". CDS is a form of insurance where buyers pay sellers an annual premium in order to gain protection against bonds failing. The seller compensates the buyer if the bonds 'default'.

"When a short seller sells a financial instrument short without first borrowing the instrument, entering into an agreement to borrow it, or locating the instrument so that it is reserved for borrowing prior to settlement ('naked short selling'), there is a risk of settlement failure," the Commission said. "Some regulators consider that this could endanger the stability of the financial system, as in principle a naked short seller can sell an unlimited number of shares in a very short space of time."

"The Regulation agreed by the European Parliament and Council addresses both short selling and CDS because CDS can be used to secure a position economically equivalent to a short position in the underlying bonds," it said. "The buyer of a naked CDS benefits from the deterioration of the credit risk of the issuer in a very similar manner to the benefit which the seller of the bonds derives from this same deterioration which decreases the prices of the bonds."

A permanent ban on the practice can be temporarily lifted if regulators believe it "could negatively affect the liquidity of sovereign debt markets" and subject to "objective elements" in the market, the Commission said.

Michel Barnier, EU Commissioner for the Internal Market and Services, said that the proposed regulations would provide greater security within the financial markets.

"Short selling did not cause the crisis, but can aggravate price declines in distressed markets," Barnier said.

"The events of autumn 2008 and those of recent months amply demonstrate the urgent need for a common European framework for short selling and CDS. By agreeing the Commission's short selling regulation just over a year after it was proposed, the European Parliament and the Council have risen to the challenge," he said.

The agreed proposals still need to be formally approved but are expected to come into force in November next year, the Commission said.