The Council of the European Union has voted to permit member states to opt out of a ban on naked short-selling of sovereign credit default swaps (CDSs), but other types of regulatory arbitrage could pose additional problems.
Following a meeting today of the Council of the European Union, which comprises representatives from European governments, member states could be allowed to lift restrictions on naked short selling of credit default swaps based on sovereign debt instruments if liquidity falls below a specified threshold, or in exceptional situations that threaten financial stability or market confidence. The ban will not apply to the short selling of sovereign debt if the transaction hedges a long position in debt instruments of an issuer.
In theory, any decision to opt out would taken by a national competent authority in liaison with the European Securities and Markets Authority, which is responsible for harmonising securities market regulation across member states.
The Council of the European Union's stance differs from that of the European Parliament, which recommended an unconditional ban in short sales of sovereign bond instruments in March 2011.
Syed Kamall MEP, Conservative shadow lead member on the negotiations for the Council of Europe, said, “Naked sovereign CDS can be a crucial financial instrument used for hedging all kinds of investments across the EU. If we ban this tool then investment in Europe’s struggling economies will risk drying up. Some banks could also see their credit lines withdrawn and a ban would make it much more expensive for governments to raise money by issuing bonds.”
European member states may not exercise their right to opt out as it could give a negative perception on the health of a country's economy.
According to Anthony Kirby, director of risk and regulation at Ernst and Young, the new regulations must include clear guidelines on when and how member states are able to lift restrictions.
“If there is a ban of naked short selling of sovereign credit default swaps that gives countries the option to simply opt out, member states are likely to do this differentially, particularly if national authorities are allowed to suspend a ban on uncovered CDSs,” said Kirby. “It is crucial to ensure that if this is the case, technical standards are applied consistently and tightly controlled.”
There may also be scope for regulatory arbitrage between euro-zone member states and countries that are either outside of the euro-zone, such as the UK, or not part of the European Union, such as Switzerland.
“It is unclear whether naked shorting of European sovereign CDS instruments will be banned in other, non-European Union or non-European jurisdictions,” said Kirby. “The biggest worry is that this will lead to legal entity tourism, i.e. firms that seek the maximum business opportunity by relocating business to the place that has the least regulatory restrictions at any one time.”
The Council of the European Union also recommended that there should be no ban on the naked short selling of equities, as long as positions are covered by the end of each trading day. Member states also omitted a new regime that would identify all short positions to regulators, a proposal that was dismissed as too costly.
Short-selling restrictions were applied on a country-by-country basis following the collapse of investment bank Lehman Brothers in September 2008. German regulator BaFin published new rules in May 2010 that prohibited naked short-selling in a select number of financial stocks and government debt, as well as CDSs based on sovereign debt. In September 2010, the European Commission appeared to take Germany's lead and announced regulatory proposals for short selling that also included private and public regulatory thresholds for the disclosure of short positions.
Following today's proposed text, the Council of the European Union will now meet with the European Parliament and European Commission to thrash out compromises. This is expected to take place before the 6 June, on which date the European Parliament is scheduled to vote on the final version of the text.