Bare necessities? The EU’s harmonised Short Selling regime targets naked sovereign CDS

After many months of discussion and divergence the EU finally reached agreement on its harmonised short selling regime on 18^th October 2011. Whilst the measures are still subject to ratification by European Parliament and Council, they are expected to come into force on 1 November 2012.

The effectiveness of regulators interfering in the operation of capital markets in such a way is of course hotly debated but for market participants having a single set of rules is at least preferable to the unilateral actions attempted and still partially in place in certain EU jurisdictions. Click here for IMS’s previous note on this subject.

The EU’s short selling regime will introduce standardised disclosure requirements across 27 member states. Disclosure to supervisors will be required for net short equity positions of 0.2% with a public disclosure necessary where the position reaches 0.5%. The disclosure levels for sovereign debt positions are yet to be specified other than it will be required for “significant positions”.

The new harmonised regime goes beyond establishing a common framework for the trading and reporting of equity short selling and includes a regulation that effectively bans the holding of naked sovereign credit default swaps (“CDS”). These instruments were designed to provide insurance in the event of a sovereign default, however, the activities of speculators have been blamed by some politicians for rendering a country default more likely. This regulation therefore intends to stop traders speculating on the creditworthiness of states, while allowing banks and investors to hedge their holdings of government bonds.

The role of CDS in exacerbating the current crises is far from agreed upon. Studies of the link between the cash sovereign bond market and its smaller CDS counterpart have in fact concluded that both markets move in tandem as opposed to the derivative market dictating or distorting the other. The argument that naked sovereign CDS positions exacerbate strained balance sheets of sovereign states is analogous to the argument that short sellers worsen strained balance sheets of corporates. Informed analysis shows that such practices are a consequence rather than a cause of the strain. Accordingly, short selling restrictions seem like silencing the smoke alarm instead of targeting the raging fire and its causes.

Whilst the ban on holding naked CDS positions may be seen as a largely political move, concerns of the potential harm the measure may introduce, are partly reflected in the final measures. In order to bring the lengthy discussions within the EU to a conclusion, opponents succeeded in including opt-out provisions. These allow national authorities to temporarily opt-out if they can demonstrate that the ban is damaging their sovereign debt market or affecting borrowing costs. To invoke the opt-out, regulators must submit a case to ESMA, the European markets regulator, providing evidence such as widening interest rate spreads or poor liquidity in the market. Whilst ESMA’s response to the request will be non-binding, in practice local supervisors will find it difficult to act contrary to its conclusions.

In addition to the opt-out provisions, the regulation provides some scope for CDS to continue to be used within a trading strategy. As well as exempting the activities of market-makers, under the terms of the deal, investors with financial contracts or a portfolio of assets that are judged to be “correlated” to the value of the sovereign debt will still be permitted to purchase the credit insurance. It remains to be seen how the regulation will be applied and whether the perceived higher regulatory risk will deter participants from the CDS market entirely or encourage a switch to non-EU markets unaffected by the rules.

If you have any questions regarding this subject, please contact Peter Moore, Stephen Burke or Alan Leale-Green. Alternatively telephone 020 7408 2448 to speak to your usual IMS contact.