Since March of 2010, credit-default swaps (CDS) in Europe have been the focus of many European regulators who are calling for greater restrictions in the swaps market. While steps have been taken to better regulate all swaps trading, CDSs in Europe have been singled out as one of the major causes for the near-collapse of American International Group in the 2008 financial crisis, as well as Greece's sovereign debt crisis in early 2010. The Greek government blamed speculators investing in the Greek CDS market for causing a large sell-off in the Athens debt and stock markets, in order to profit from the violent movement in prices.
Credit-default swaps are complex financial instruments that are meant to control an investor's exposure to credit risk. They function somewhat like an insurance contract in that they provide protection against specific credit events. In a typical credit default swap, one party will sell a default protection plan in case a credit default event occurs with the instrument. In return, the buyer of the default protection plan pays the seller a periodic premium. One of the most controversial variations of a CDS is the "naked" credit-default swap, which involves a buyer purchasing a default protection plan on a bond or similar financial instrument without actually owning it, making it a purely speculative gamble. Individuals who call for the banning of naked CDSs say they are like taking out an insurance policy on your neighbor’s house; they encourage the buyer of the protection plan to want the financial instrument to go into default.
On March 10, 2010, German Chancellor Angela Merkel, along with representatives from France, Luxembourg, and Greece announced that their governments are supporting initiatives to completely ban speculative trading in the credit-default swap market. The representatives suggested Europe should forge ahead on its own in taking extreme measures to curb trading in the CDS market, even if the U.S. didn't go along (the U.S. has also called for limiting the market, but haven't suggested banning CDSs).
U.K.'s Financial Services Authority has also shown support for much stricter regulations on CDS trading, and especially naked CDSs. The chairman of the FSA, Lord Turner, warned that naked trading in corporate CDSs could force companies into default. In a speech that he gave in March of 2010 he warned: "We need to think about whether we are being radical enough on credit default swaps . . . as to whether naked CDSs should be allowed", although he did also recommend that the issue should be looked into more closely, saying that it was over-simplistic to assume that the entire CDS market was dangerous to financial stability.
Germany's "Naked" Credit Default Swap Ban
On May 19, 2010, Germany announced that it was banning all naked CDS trade in an attempt to limit the "exceptional volatility" in euro-area bonds. The ban was also made with the intention of building momentum for financial-market regulation. Germany also announced a ban on the short-selling of shares in Germany's leading 10 finance houses. The ban is set to last until March 31, 2011.
Germany's allies looking for a ban on "naked" CDS trading expressed reservations about the move however. France and other European Union officials said they had not been consulted about Germany's unilateral move and called for concerted action in financial regulation.
- In a statement about Germany's move, French Economy Minister Christine Lagarde said: "It seems to me that one ought to at least seek the advice of the other member states concerned by this measure". She also affirmed that France would not follow Germany in banning naked short-selling on European debt.
- Michel Barnier also issued a statement against the move, saying that the measures would have been more effective if coordinated at European level: "It is important that member states act together and that we design a European regime to avoid regulatory arbitrage and fragmentation both with the EU and globally".
European Commission's Proposed Regulation
September 15, 2010
This proposal by the European Commission includes their proposed regulations regarding short selling and credit-default swaps. The proposal includes new requirements for transparency in the financial instruments, new intervention powers for financial authorities in the EU (allowing them to temporarily prohibit short selling), and much greater restrictions on "naked" CDS trading.
The proposal divides short selling into two types: ‘’covered short selling’’, where the seller has borrowed the security, or made arrangements to ensure they can be borrowed before the short sale and uncovered, or ‘’naked short selling’’, where at the time of the short sale the seller has not borrowed the securities or ensured they can be borrowed. The European Commission proposes to ban the trading of naked short selling and only allow covered short selling.
The European Commission also proposes to give the European Securities and Markets Authority (ESMA) the ability to temporarily prohibit the trading of CDSs and short selling in the case of a financial emergency.