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EU Consultation on Derivatives, market Infrastructures, Short Selling and Credit Default Swaps

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EU Commission, DG Internal Market: In order to advance swiftly in completing the necessary reforms to ensure a safe and stable financial system in Europe, the European Commission has launched two consultations in the area of financial services. One consultation focuses on possible measures to enhance the resilience of derivatives markets. The other consults on options to be considered for a future proposal that would deal with potential risks arising from short selling and Credit Default Swaps.

New powers for European regulators to ban or restrict credit default swaps on a European Union-wide basis could be on the table as EU officials in Brussels respond to political pressure to crack down on speculative trading. In an early stage consultation document, released on Monday, European Commission officials suggested that powers for market authorities to temporarily prohibit or restrict the use of CDS in certain emergency circumstances could be a possibility. They suggested that these could come into play when there is a “serious threat to financial stability or to market confidence in a member state or the EU”. At that stage, the authorities would be able to ban or restrict the purposes for which investors or traders could enter CDS deals if these related to the potential default by a member country or the EU itself. Alternatively, they could cap the value of such transactions. The idea comes after weeks of controversy surrounding the way in which CDS related to Greek sovereign debt were traded during the recent crisis, and heavy political pressure from countries such as France and Germany to crack down on some forms of speculative trading. The commission’s consultation paper also moots introducing new rules to make short-selling generally – of EU shares, EU sovereign bonds or, possibly, all financial instruments traded on EU-based markets – more transparent. Disclosure would have to take place at new, lower thresholds. In addition, the paper sets out options for banning or restricting “naked” short-selling – where traders or investors have sold securities which are not owned, and have not ensured that they can be borrowed. The consultation will last until July 10, and the commission is promising to produce firm proposals by the end of the summer. But key details – such as who would decide on whether an “emergency situation” existed – have not been fleshed out at this stage, and views are likely to be very diverse. In a separate consultation paper, also issued on Monday, the commission also sought more views on how best to regulate over-the-counter derivatives, or swaps. Brussels has been working on proposals here for many months, and the core thrust of the upcoming legislation will be to encourage much more centralised clearing of swaps. But officials are seeking more input from interested parties on the process for determining which contracts have to cleared centrally; how best to exempt companies that use swaps for genuine hedging purposes; what requirements should be placed on central counterparties; and grounds on which CCP based outside the EU should be allowed to provide clearing services to entities established within the 27-country bloc.



Target group(s)
All citizens and organisations are welcome to contribute to this consultation. Contributions are particularly sought from representatives of Member States' authorities, central counterparties, credit institutions, investment firms, fund managers, insurance companies, non-financial firms and investors (including consumers).

Period of consultation
From 14.06.2010 to 09.07.2010

Objective of the consultation
Obtaining information from Member States, market participants and other stakeholders on the measures aimed at enhancing the resilience of derivatives markets and market infrastructures.


On 25th September 2009, G-20 leaders agreed4 that: "All standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements".


What is the objective of the measures put out for consultation?

The consultation document outlines the Internal Market DG's current thinking on how to implement four of the policy actions that were announced in October 2009, notably:

  • Mandatory clearing of all "standardised" OTC derivatives;
  • Mandatory reporting of all OTC derivatives to trade repositories;
  • Common rules for Central Counterparties (CCPs) and for trade repositories; and
  • More transparency through reporting to trade repositories.

Other measures are foreseen later in 2010 or beginning of 2011, notably the revision of the Capital Requirements Directive, MiFID (Market in Financial Instruments Directive) and the Market Abuse Directive.

On substance, the Commission's future proposal will focus on four points:

  • Reducing counterparty credit risk by mandating CCP-clearing where possible
  • Increasing transparency by mandatory reporting to trade repositories
  • Ensuring safe and sound CCPs through stringent and harmonised organisational, conduct of business and prudential requirements.
  • Improving efficiency in the EU post-trading market by removing barriers preventing interoperability between CCPs while preserving the safety of them.

Short Selling and Credit Default Swaps


Target group(s)
All citizens and organisations are welcome to contribute to this consultation. Contributions are particularly sought from market participants, national governments and national competent authorities.

Period of consultation
From 14.06.2010 to 12.07.2010

Objective of the consultation
The purpose of this public document is to consult market participants, governments, regulators and other stakeholders on possible provisions to be considered in a forthcoming Commission proposal for stand alone legislation dealing with potential risks arising from short selling.



Short selling is the sale of a security that the seller does not own, with the intention of buying back an identical security at a later point in time in order to be able to deliver the security. Short selling can be divided into two types:

  1. "Covered" short selling is where the seller has borrowed the securities, or made arrangements to ensure they can be borrowed, before the short sale.

  2. "Naked" or "uncovered" short selling is where the seller has not borrowed the securities at the time of the short sale, or ensured they can be borrowed.

A Credit Default Swap (CDS) is a derivative which is sometimes regarded as a form of insurance against the risk of credit default of a corporate or government (or sovereign) bond. In return for an annual premium, the buyer of a CDS is protected against the risk of default of the reference entity (stated in the contract) by the seller. If the reference entity defaults, the protection seller compensates the buyer for the cost of default.

In addition to short selling on cash markets, a net short position can also be achieved by the use of derivatives, including Credit Default Swaps (CDS). For example, if an investor buys a CDS without being exposed to the credit risk of the underlying bond issuer (a so-called "naked CDS"), he is expecting, and potentially gaining from, rising credit risk. This is equivalent to short selling the underlying bond.

The intention is that the measures envisaged on short selling should:

  • ensure Member States have the power to act to reduce systemic risks and risks to financial stability and market integrity arising from short selling and Credit Default Swaps,
  • facilitate co-ordination between Member States and the European Securities Markets Authority (ESMA) in emergency situations;
  • increase transparency on the short positions held by investors; and
  • reduce settlement risks linked with uncovered or naked short selling.

What options are included in the consultation document?

The options envisaged can be grouped into three types:

  • Powers for competent authorities to temporarily restrict or ban short selling and Credit Default Swaps in emergency situations (subject to coordination by ESMA);
  • Measures to increase transparency to regulators and the market about short selling positions, including those obtained through the use of derivatives; and
  • Measures to reduce settlement risks of uncovered or naked short selling.

The options under consideration also foresee powers for competent authorities to enforce the rules and the possibility of some limited exemptions (for market makers and shares whose principal market is outside the EU).

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