Peter Moore, head of regulation and compliance at UK compliance consultancy, The IMS Group

Naked sovereign CDS ban is difficult to comprehend

Peter Moore (pictured), head of regulation and compliance at UK compliance consultancy, The IMS Group, responds to yesterday’s EU agreement regarding regulation of credit default swaps (CDS) and short selling…

The ban on naked sovereign CDS is not consistent with findings of research commissioned by the European Parliament (which found that a ban would harm market liquidity, impair instrument valuation and could ultimately increase borrowing costs for sovereign states) and with research by the German Bundesbank (which found that the larger cash bond and sovereign CDS markets were reacting to events as opposed to either dictating or distorting them). This makes yesterday’s announcement, described by Michel Barnier, the EU’s financial services chief, as one “which strengthens financial stability” very difficult to comprehend.
 
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.  However, informed analysis shows that such practices are a consequence rather than a cause of the strain meaning that the argument runs the risk of missing the true causes of the strain.
 
The debate on this subject had deadlocked the EU for months.  The countries that opposed the ban agreed to it after the European Parliament said they could opt out of the prohibition if it was damaging their government debt market.  An opt-out request would be submitted to ESMA which would provide a non-binding response within 24 hours. 
 
In conclusion, this is a prohibition of a certain capital market practice introduced upon a disproved perception that the practice created or exacerbated stress, with an opt-out available upon the demonstration of actual stress. 
 
This should raise concerns about the EU’s decision making processes at a time when so many regulatory provisions are currently being developed by it."
 
Harmony on share short selling measures across EU member states is welcomed.  This is the one aspect of the new regulation that we have been cautiously telling clients to look forward to. The rules in this area, a “maximum harmonisation regulation” which imposes a ceiling on market regulation, will relieve market participants of having to ascertain and keep track of a multitude of short selling measures across 27 member states in order to establish what the different disclosure thresholds are and what issuers may be out of bounds for short sellers from time to time. 

Market participants should also find that publicity and possibly also advance notice on periodic short selling measures should improve substantially, at least compared to the Autumn of 2008. However, the true price of this uniformity may still emerge if the UK finds itself outvoted at a time when the EU is contemplating a uniform response to difficult market conditions. The naked sovereign CDS issue is a tangible example of the UK being outnumbered on regulatory policy.

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