Parliament on Tuesday voted into law a regulation to curb short selling and trading in credit default swaps (CDS), a financial product for insuring against default. The rules will impose much more transparency and virtually ban certain CDS trades, thereby making speculation on a country's default more difficult.

This is one of the key regulations pushed through by the Commission to tackle the financial crisis. Both short selling and CDS trading are accused of having fuelled market volatility, with CDS trades moreover having been widely blamed for potentially aggravating Greece's troubles.

Limiting speculation on a country's default - a key win for Parliament

Parliament obtained a ban on naked CDS trading (purchasing default insurance contracts without owning the related bonds). Purchasing Italian CDS, for example, will now be possible only if the buyer already owns Italian government bonds or a stake in a sector highly dependent on the performance of these bonds, such as an Italian bank – in the event of a Italian default, Italian banks would certainly suffer significantly.

The sole exception is an option for a national authority to lift the ban for a maximum of 12 months in cases where its sovereign debt market is no longer functioning properly, and then possibly renew it for a further 6 months. Even this possibility would be closely circumscribed, because the text specifies a limited number of indicators which could justify the regulator's action. Moreover, within 24 hours, the European Securities and Markets Authority (ESMA) would publish an opinion on its web site as to the utility of suspending the ban. A negative opinion from ESMA would have political weight.

Welcoming the ban, rapporteur Pascal Canfin (Greens, FR) said: "These rules prove that the EU can act against speculation when the political will is there. This rule will make it impossible to buy CDS for the sole purpose of speculating on a country's default."

Curbing reckless short selling

The majority of MEPs originally advocated introducing a requirement to convert a naked short sale, the riskiest sort of short selling, to a normal short sale within a single trading day.  This so-called hard "locate and reserve rule", whereby a trader must not only notify from where it plans to borrow the shares in question but must also have a guarantee that it will indeed be able to borrow them, was finally diluted. The regulation now requires the trader to locate and have a "reasonable expectation" of being able to borrow the shares from the located party. ESMA however will determine measures for judging what may be deemed a “reasonable expectation”.

Much more reporting

Another key to strengthening the Commission proposal is stepping up reporting requirements. A lack of information was one of the main problems for supervisors before the crisis. The extra information to be provided to national and European supervisors under the regulation will allow them to carry out their preventive work better, by alerting them earlier to potential risks.  For example, supervisors would be informed of large short positions as soon as these positions account for 0.5% of the issued capital.

ESMA in the driving seat

MEPs from groups sponsoring the deal also managed to preserve the powers of the EU's financial markets watchdog, ESMA, in particular to restrict short selling, as an arbiter of a national authority's wish to introduce measures to address exceptional situations, and also to require other authorities to introduce exceptional measures to deal with difficult situations.

"The new powers for ESMA will allow better coordination at EU level in times of crisis", Mr Canfin said, adding however that, "it would have been better had ESMA had similar powers over decisions relating to sovereign debt, but the Member States refused".   

The resolution was passed with 507 votes in favour, 25 against and 109 abstentions.

Next steps

The new regulation must be formally approved by the Council in the coming weeks, and will enter into force in November 2012.

Procedure: Codecision (1st reading)

Debate: 4 July 2011

Vote: Tuesday 15 November