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Naked Short-Sales, OTC Derivatives Face EU Limits

By Ben Moshinsky
September 15, 2010, 10:22 AM EDT

(Updates with comments from hedge-fund group in 15th paragraph.)

Sept. 15 (Bloomberg) -- Naked short-sales of shares and government bonds would be limited and some over-the-counter derivatives trades forced through clearinghouses under European Commission proposals to safeguard financial markets.

Frequent traders of some OTC derivatives in Europe will be forced to use central clearinghouses to close sales, while naked short-sellers would be required to submit proof they can access the underlying security to settle a trade designed to profit from falling prices, under two separate initiatives announced in Brussels today.

“In distressed markets, short selling can amplify price falls, leading to disorderly markets and systemic risks,” Michel Barnier, the European Union’s financial services commissioner, said in an e-mailed statement.

The rules on short-selling would bring the EU closer to the stance taken by Germany, where Chancellor Angela Merkel banned some naked short-selling in May. Merkel and French President Nicolas Sarkozy argued that some bets against stocks and government bonds should be curbed as the Greek debt crisis made markets more volatile.

The EU bill on derivatives clearing is part of a package of laws to strengthen regulation following the worst financial crisis since the Great Depression. The plan is aimed at limiting losses in the event of a default by a major counterparty.

‘Wild West’

“No financial market can afford to remain a Wild West territory,” Barnier said. “OTC derivatives have a big impact on the real economy, from mortgages to food prices.”

The commission, the executive arm of the 27-nation EU, announced the proposals for discussion by the European Parliament and member states. U.S. and European regulators are pushing for tighter oversight of the $605 trillion over-the- counter derivatives market.

To encourage traders to use central counterparties, OTC derivatives not cleared centrally will face increased capital charges, to be outlined in a revision of the EU’s rules on bank reserves at the end of the year.

The capital rules will implement agreements made by the central bankers and regulators of the Basel Committee on Banking Supervision announced on Sept. 12.

Banks are “concerned about requirements for potentially higher levels of collateral and capital,” the European Banking Federation, a Brussels-based trade group, said in an e-mailed statement.

‘Crucial Points’

“These measures are crucial points in the strict regulatory agenda banks are facing and must be carefully weighed, both individually and as a whole,” Guido Ravoet, secretary general EBF, said in the statement.

The proposed law on short-selling would require traders to notify authorities of any short position exceeding 0.2 percent of issued capital, and tell the market of positions exceeding 0.5 percent.

“We have a concern about public disclosure at low thresholds,” Kevin McNulty, chief executive of the International Securities Lending Association, said in a telephone interview. “At that level, it artificially reduces short-selling.”

The rules would also give regulators emergency powers to require more disclosure or temporarily ban short-sales of equities and credit-default swaps on bonds.

“We do hope however that new powers to ban short selling are never used,” Andrew Baker, chief executive of the Alternative Investment Managers Association, said in an e-mailed statement. “Such bans have never worked.”

‘Therapeutic Effect’

“These proposals will have a very therapeutic effect,” said Michael Greenberger, a professor at the University of Maryland School of Law, said in a telephone interview earlier this week. “The problems speculators pose in markets far outweigh concerns about liquidity and financial costs.”

In the U.S., regulators and Congress rejected a proposed ban on naked swaps last year, with House Financial Services Committee Chairman Barney Frank saying “there was concern that a broad grant to ban abusive swaps would be unsettling,” and U.S. Treasury Secretary Timothy F. Geithner saying he doesn’t think such a measure would have merit.

‘Nefarious Practice’

The EU proposals were criticized by some groups for failing to require an outright ban on naked short-selling.

The commission “failed to grasp the nettle” to “ban this nefarious practice,” Pascal Canfin, a French Green party member of the European Parliament, said in an e-mailed statement.

Short sellers borrow assets and sell them, betting the price will fall, buying them later and pocketing the difference. In naked short-selling, traders never borrow the assets, so betting is unlimited.

Credit-default swaps are derivatives that pay the buyer face value if a borrower -- a country or a company -- defaults. In exchange, the swap seller gets the underlying securities or the cash equivalent. Traders in naked credit-default swaps buy insurance on bonds they don’t own.

The rules on OTC derivatives would force traders to record contracts with a central data bank known as a trade repository, and hand powers to European regulators to decide what type of derivatives must be cleared by a central counterparty.

A derivative is a contract between two parties linked to the future value or status of the underlying asset to which it refers, including the development of interest rates or price of commodities such as oil or wheat. An OTC derivative is one privately negotiated between two parties, rather than being traded on an exchange.

Clearinghouses operate as central counterparties for every buy and sell order executed by their members, who post collateral, reducing the risk that a trader defaults on a deal.

--With assistance from Abigail Moses in London. Editors: Peter Chapman, Christopher Scinta

To contact the reporters on this story: Ben Moshinsky in Brussels at [e-mail];

http://www.businessweek.com/news/2010-09-15/naked-short-sales-otc-derivatives-face-eu-limits.html