Europe’s political elite is battling daily against the financial markets machine, so they might see the new short-selling regulation (SSR) as a victory of sorts.
It is, after all, one of the rare occasions when a new piece of financial regulation is harmonized across the 27 members of the European Union, and Iceland, Liechtenstein and Norway as well.
However, if it is a victory for the European Commission, it is potentially a disaster for Europe’s financial markets. Instead of a positive force for good, as was seemingly intended, negative consequences abound.
Ask any large sell-side or buy-side institution active in the European equity, bond and derivative markets, and they will likely say that the greatest single impact these new regulations have had, and continue to have, is confusion.
On almost every level, the new regulation poses more questions than it answers. When markets are confused, markets rarely improve.
Of course, no new prohibitive piece of financial regulation is ever welcomed with open arms, but the level of dissent this time should at the very least prompt the EC to pause for thought.
Indeed, it is not just investment banks and investors who have concerns – Germany, the UK and four other EU member states have also openly criticized the EC for ignoring the advice of the European Securities and Markets Authority on this issue, and the manner in which the financial regulatory process has been conducted.
In particular, they are miffed about the short-selling ban on sovereign credit default swaps (CDS).
The main objective of the new regulations is to try to ensure the borrowing costs of Portugal, Ireland, Italy, Greece and Spain (Piigs) are not inflated to unsustainable highs by speculators taking a punt on a country’s demise via its bonds and CDS.
Specifically, uncovered sovereign CDS buying – when the buyer has no exposure to the debt of the country – and uncovered short-selling of EU sovereign debt are banned.
What is permitted, however, is sovereign CDS protection buying, if it is hedging an exposure to the sovereign or institutions correlated to the sovereign debt in that country – in other words, a covered position.
The problem with this is that there is widespread confusion about what is covered and what is not.
Liquidity in the sovereign CDS market has been hit hard as a result, especially since March when the regulations came into force.
The risk now is that the new regulation has the exact opposite effect to what was intended – forcing up the borrowing costs of the Piigs because counterparties will pass on the increased costs due to the illiquidity this new regulation has brought about.
The potential pitfalls do not end there.
The regulation will also have a substantial impact on hedging as prices rise, on price volatility in sovereign bonds, CDS, and, by extension, on the bonds and CDS of systemic banks and utilities, which are highly correlated proxies to their sovereign. Portugal Telecom, for example, will be easier to short than Portugal.
In addition, market-makers, particularly hedge funds, could take a hit as well, impacting liquidity and pricing in other areas, such as trading new issue bonds and equities.
Indeed, equity brokers warn that the restrictions on short-selling shares threaten to reduce liquidity in small to mid-cap stocks, potentially preventing these businesses from raising capital at a time when they need it most.
It is the sovereign CDS market, however, that has been hardest hit.
EU politicians appear to have succeeded in making it much more difficult for brazen speculation on stressed eurozone countries, but banning the shorting of EU governments via CDS is not going to solve the crisis.
Instead, they have shot the messenger.
The deeper problem is that investors are rightly worried about the ability of a government to carry its people to endure what looks likely to be a prolonged period of depression-like economics.
If only the market could buy protection against the stupidity of political decision-making, some say. Others just comment: "SSR – what a joke."