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25th Aug 2019

Brussels to tame 'Wild West' derivatives and short-selling

In the latest part of its endeavour to bring an end to the light-touch regulatory climate that produced the economic crisis, the European Commission has proposed a series of rules intending to shine a light on the until-now murky trading in some of the market's more complicated financial practices: derivatives and short-selling.

In the unveiling of the first of two bills, internal market commissioner Michel Barnier on Wednesday proposed that traders of what are called 'over-the-counter' (OTC) derivatives pass their agreements through clearinghouses in order to bring greater security to financial markets.

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  • Commissioner Barnier sees himself as the sheriff and naked short sellers are the bandits (Photo: Joekoz451)

"No financial market can afford to remain a Wild West territory," said Mr Barnier. "OTC derivatives have a big impact on the real economy: from mortgages to food prices. The absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from."

A derivative is in essence a bet on the price movement of an underlying asset. The concept has existed since the 18th Century, but the OTC derivatives market - those derivatives not traded on an open exchange but rather privately and away from regulatory oversight - basically a private bet - has grown exponentially over the last decade.

As of December last year, the market had a notional value of €615 trillion, an increase of 12 percent on 2008.

But currently, despite the staggering sums involved, there is little reliable information on what is going on in the OTC derivatives market. There are no public prices available, no public information as to who is entering deals with whom, over what period of time, relating to what underlying asset or for which amounts.

Derivatives can result in large losses if the price of the underlying asset moves against them significantly, and indeed, in the US, the near-collapse of Bear Stearns in March 2008, the default of Lehman Brothers in September of the same year and the bail-out of AIG, all represent to varying degrees problems with the OTC derivatives market. The recapitalisation of AIG cost the US government $85 billion.

In response, the commission is proposing that OTC derivative traders will now have to submit information on contracts to central data centres, known as trade repositories. This information could then be available to one of Europe's new financial supervisory authorities, the European Securities and Markets Authority (ESMA), who can keep an eye on potential dangers, such as an over-accumulation of risk, as well as monitor who owes what to whom, and ring the alarm bell early on.

Additionally, to mitigate losses creating a chain of fall-out when one party does not have the cash to make payments when they are due, the commission's proposal would require that standard OTC derivatives be cleared through central counterparties (CCPs). These are entities that place themselves between two sides of a transaction, being a 'buyer to every seller' and a 'seller to every buyer'.

CCPs are commercial firms whose main purpose is to manage risk. At the moment there are about a dozen such companies, mostly located in Europe and the US.

As a sort of firewall between parties, the CCPs would prevent the situation where the collapse of one side leads to the collapse of the other, potentially creating a chain of fall-out that could put the entire system at risk.

Short-selling

In the second of Mr Barnier's proposals, the commission would like to see greater disclosure of details relating to short-selling - another financial technique whereby investors 'borrow' an asset, then sell it on before buying it back (hopefully at a lower price) and returning it to the lender.

Essentially, the process sees the investor make money when an asset declines in value.

Mr Barnier said: "In normal times, short selling enhances market liquidity and contributes to efficient pricing."

The worry here is that in the situation of a distressed market, short-selling can amplify price falls, creating a spiral of negative prices and ultimately to a risk to the system.

As a result of such risks, a number of EU member states introduced emergency bans on short-selling in the autumn of 2008.

The commission proposal for greater transparency and co-ordination in this market does not go this far, but require that all such trades be marked as 'short' so that regulators can identify them. Also investors will have to disclose their significant short positions, again through a clearinghouse for regulatory supervision.

Regulators will also be given the power to restrict or ban short-selling in emergencies.

There will also be a crack-down on so-called naked short selling - the same form of transaction, but where the underlying asset has not actually been borrowed. This is in effect a bet on someone else's property.

Under the new rules, an investor would have to prove that the asset has actually been borrowed.

Both of Mr Barnier's proposals now pass to the European Parliament and the EU member states for negotiation and adoption.

Once adopted, they would apply from July 2012.

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