Cheat sheet: Short selling / naked CDS

20 February 2012

Factsheet

Short selling involves selling a security one does not own and replacing it with one bought at a later date to benefit from a fall in price. Credit default swaps (CDS) are derivatives that protect against default, paying out like insurance policies if the creditor (a company or a country) defaults. Their value usually rises as a default looks more likely.

Legislative activity

Short selling and the “naked” use of CDS were widely used to speculate against the shares of major European banks during the financial crisis and against the sovereign debt of European countries. The resulting market instability triggered a series of bans and restrictions on those practises by national regulators around Europe.

In September 2010, the Commission proposed a Regulation to bring these measures into a common regulatory framework. The intention was to harmonise short selling rules across the EU, harmonise regulators’ powers when there is a serious threat to financial stability, and improve coordination between Member States at such times.

The text proposed, among other things, to improve disclosure of short positions and to set restrictions on “uncovered” or “naked” short positions in certain securities. Uncovered short selling is where a security is sold short without the seller first having borrowed an identical security to “cover” their position. The “naked” use of CDS is when speculators buy protection against a default without owning the underlying credit or bond.

Calendar

21 February 2012 – European Council endorses inter-institutional agreement
15 November 2011 – European Parliament plenary adopts agreement
18 October 2011 – EP and Council agree compromise
11 July 2011 – Finance Watch publishes position paper
7 March 2011 – Parliament Economic and Monetary Affairs Committee adopts its negotiation position drafted by Pascal Canfin (Greens, France)
15 September 2010 – Commission publishes draft Regulation