EU Tightens Short-Sales Norms

In an effort to restrain the excessive risk-taking attitude of traders while dealing with the complicated financial products such as derivatives, the European Union (EU) has proposed a number of initiatives for regulation on short-selling and credit default swaps.

According to the proposal, participating traders need to disclose to the regulators any short position that represents more than 0.2% of the company’s share. If the short position exceeds 0.5% of the company’s share, a public disclosure has to be made.

The Why and How of Short-Sale

Short-selling refers to the sale of a security that a seller does not yet own but intends to buy back an identical security at a later date to deliver it.

This mode of trading is used by market participants including hedge funds, pension funds and insurance companies, investment banks, market makers and individual investors. The investors make short-sales with the intention of buying them later at a lower price. The difference between the selling and the buying price is the gain. It is this practice of the investors which has been blamed for the significant plunge of bank stock prices during the financial crisis as investors made short position on the security and aimed at buying them at lower price.

The EU Proposal

The EU proposals also aim at establishing a regulatory agency – the European Securities Markets Authority – for the overall supervisions of the derivatives market. The authority would be bestowed with powers to make a temporary restriction or ban short-selling in any financial instrument when required.

Additionally, the naked short-selling practice would also be restricted. Naked short-selling refers to a situation where the seller has neither borrowed nor made any arrangements to borrow the security. As per the proposal, in order to execute a short-sale, an investor must have borrowed the instruments concerned or have entered into an agreement to borrow them. Disclosures of short positions in sovereign debt would be required as well. The other proposals on financial derivatives trade also have a negative impact on hedge funds.

This proposal would be discussed by the European governments. If accepted by the European Parliament and the 27 member states of the EU, it would become effective in July 2012.

If implemented, we expect these measures to impact the business of a number of banks who are significant players in this market. These include Deutsche Bank AG (DB), Barclays plc. (BCS), Goldman Sachs Group Inc. (GS), Citigroup Inc. (C), Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM). It is thought that the EU is opting for stringent financial regulations than the U.S., thereby making the market less attractive for investors.

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