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European institutions are trying to limit speculation on the sovereign debt

Published on , , Sofia

While trying to get the debt crisis under control, saving three euro area countries, the EU is making efforts to regulate certain financial instruments, which are believed to be related to the increase of public debt - short selling and credit default swaps (CDSs).

With short selling the seller does not own the bonds, but he is selling them with the intention of buying it back at a later point in time, expecting to profit from the price margin. Even more frapant is the case with the so called naked short selling, when the seller does not even borrow the securities prior to the short sale. Credit default swaps (CDSs) represent a form of insurance against default. It is believed that many have benefited by buying "naked" CDSs - without having any bonds to be insured. This creates incentives investors to speculate against the debt issuer, which increases their profits, but also increases issuer’s risk, the interest rates on his loans and, accordingly, his indebtedness. This is exactly what is happening to Greece, for example – the owners of the naked CDSs are benefiting from spreading rumours that the country will go bankrupt (or will restructure its debt), because it raises the price of their CDSs.

As a result of the crisis, European countries have taken various measures to these financial instruments (Germany, for example, banned naked short sales), which necessitates to create a common harmonised approach and a mechanism for crisis response. Last September the European Commission presented its position on the regulation of OTC derivatives and short sales. Based on the ideas of the Commission and on the compromise proposed by the Hungarian presidency, the Council of EU finance ministers (ECOFIN) adopted its position on short selling and CDSs. On this basis the Council is starting negotiations on the subject with the European Parliament.

For its part, at its plenary session on 6 June, the Parliament will discuss a report on Short Selling and certain aspects of Credit Default Swaps of MEP Pascal Canfin (Greens/EFA, France). The report has already been adopted by the parliamentary Committee on Economic and Monetary Affairs.

It is expected the most controversial point to be Parliament's possible urge the naked CDSs to be banned. The Council has not accepted the ban, despite the insistence of Germany the EU to follow its example, but allowed for temporary restrictions on naked short sales and CDSs transactions. At this stage there is a majority in the European Parliament in favour of the ban.

EP rapporteur on short-selling and CDSs Pascal Canfin commented, quoted by EurActiv: “The Council approach on sovereign debt is paradoxical. Whereas the initial proposal aimed to reduce speculation on sovereign debt in the time of a crisis, the text adopted by the Ecofin suggests relaxing these provisions in case of crises. This will facilitate speculation on sovereign debt of countries facing fiscal difficulties.”

Strong argument against a total ban of the naked CDSs is the potential negative effect on the liquidity. During the Brussels Economic Forum 2011 MEP Sharon Bowles (ALDE, UK), the chairman of the parliamentary economic committee, paid particular attention to the relationship between short sales and sovereign debt in the context of country’s attempts to conceal the traces of their debts: “Certainly there hasn’t been enough disclosure of who is exposed to what in terms of which countries on which banks are exposed and where. It’s probably too much secrecy around the whole issue of sovereign debt and who is owning what. Some of the resistance against some of the short selling measures actually came from the fact you would have to reveal who was owning the sovereigns and member states started to get a little bit sensitive about that.”

In ECOFIN they don’t want to ban naked sovereign CDSs, Ms Bowles noted, admitting that at the moment nobody knows what is the right decision. We are all aware that if we ban them it may seriously affect liquidity, she explained, adding that she wasn’t sure that right now we were ready to risk with anything that might affect liquidity.

According to the plan this legislation should be adopted by the end of June. Achieving this goal will depend on the progress of negotiations between the Council and the Parliament.

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