15 Sep 2010

EU proposes curbs on 'Wild West' trading

The European Commission has published draft rules on trading in complex financial products, saying it currently operates in a "Wild West territory".

The commission thinks that short-selling can worsen market instability

The body wants to create a watchdog to monitor the derivatives market - products used to make bets on assets without buying them.

Officials also want to assess the extent of short-selling, when traders bet on asset prices falling.

The practices have widely been blamed for causing economic instability.

Derivatives and short-selling are viewed by some as contributing to the eurozone debt crisis, which led to major market instability.

In May this year, during a period of heightened uncertainty on the markets, Germany made a surprise decision to temporarily ban some types of short-selling of financial products.


Unregulated

It is hoped that common standards across the EU will improve transparency on derivatives trading in the bloc.
 
The derivative market has grown over the last decade. At the end of December 2009, the value of traded over-the-counter (OTC) transactions was estimated at $615 trillion (£397 trillion).

Because they are traded over-the-counter, or off-exchange, they escape the watch of regulators.

Under the commission's proposals, a new watchdog would be created to monitor the exchanges.

"No financial market can afford to remain a Wild West territory," Michel Barnier, the commissioner leading the proposals, said.

"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," he added.


Transparency

Short-selling - a technique that sees investors borrow an asset, and then sell it on to the market before returning it back to the borrower with the aim of making a profit - will also be subject to greater regulation.

European single market commissioner Michel Barnier wants to enforce EU-wide regulations that will make investors disclose more details of their so-called "short positions" in shares to a central database.

The suggested new rules also include a requirement that these trades go through a central clearing house, to ensure that investors have enough cash to pay up if they lose the bet.

Mr Barnier has, however, underlined the fact that short-selling itself can be useful and legitimate, but that it can become a problem when people deliberately manipulate a market.

He also highlighted that in times of economic uncertainty, it can disrupt markets even further.

"In normal times, short-selling enhances market liquidity and contributes to efficient pricing. But in distressed markets, short-selling can amplify falls, leading to disorderly markets and systemic risks. Today's proposal will increase transparency for regulators and markets," the commissioner said.

The draft regulations also include a clamp-down on "naked" short-selling, when a trader sells a financial instrument he has not yet borrowed. A suggested requirement is that to enter a short sale, the investor must have already borrowed the assets or entered into an agreement to borrow them.

The proposals will now have to be approved by the European Parliament and the Council of Ministers before they can become law.

Once adopted the regulation would apply from 2012.



Analysis
by Ben Shore, Europe business reporter, Brussels

While the language surrounding financial regulation can be bewildering, the numbers are sobering.

At the end of 2009 the value of the so called over-the-counter derivatives market was a staggering £397 trillion.

When you consider that an over-the-counter derivative is, in essence, a financial bet between two investors made away from the open market it is quite easy to see why the EU might want to regulate.

The proposals include a requirement that investors report these kind of trades to a central data centre, the idea being that at least someone ought to know what's going on.

The EU is also pushing for many of these transactions to be put through clearing houses so everyone can be certain the investors have enough cash to pay up if they lose the bet.

On short selling, where investors bet that the price of a stock will go down, EU bureaucrats want investors to make sure they can actually complete the transaction they have promised to make.

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