European Union finance ministers discuss on Tuesday whether regulators should curb the sovereign credit default swaps (CDS) market after Greece accused speculators of amplifying its debt woes.
Jose Manuel Barroso, president of the EU's executive European Commission, said last week the sector should be studied for a possible ban on naked CDS selling but faces pressure from some states to take more urgent action.
The industry sees the issue as a diversion from the main problem of ballooning Greek debt, an excuse to restrain London's financial center, and as another stick to beat hedge funds which account for up to a fifth of CDS activity.
WOULD A BAN MAKE A DIFFERENCE?
Naked selling is where the holder of a CDS contract, a type of insurance against a country or company defaulting on its debt, has no stake in what is being insured. Policymakers view them as a negative punt.
German regulator Bafin said last week there is no evidence of major speculation in Greek sovereign CDS and its British counterpart, the Financial Services Authority, said it would be difficult to define what is naked selling or speculation.
The value of Greek CDS is about $9 billion, which the industry says is too small to determine prices in the much larger Greek debt market, estimated at $400 billion.
Industry officials fear that to make a ban work, regulators would also have to ban naked selling in corporate CDS, a much larger sector and more widely used.
Analysts warn countries could suffer a buyers' strike on their debt or having to offer higher government bond yields if they cannot be insured. Investors could also be disadvantaged by the removal of an early warning system.
HOW WOULD IT BE APPLIED?
Industry officials estimate London trades around 75 percent of emerging market sovereign CDS -- the bulk of sovereign CDS -- with five main dealers: Deutsche Bank, JP Morgan, Goldman Sachs, Morgan Stanley and Barclays. The rest is transacted in New York.
A ban would have to be applied on a transatlantic basis at a minimum to be effective. The United States has shown no appetite for a ban and Britain's FSA sees no case for immediate action.
Barroso wants the matter discussed at the G20 meeting of leading countries in June to thrash out a global approach and avoid brokers gaming the system.
The pressure for immediate action may have been reduced as the cost of insuring Greek debt against default has fallen as the market increasingly believes that euro zone powers will agree concrete plans, perhaps on Monday, to bail out the country if need be.
A review of the EU's market abuse and securities trading rules (MiFID) this year is also another channel that could be used to crack down on abusive selling of CDS contracts. Industry officials believe MiFID could be used now to suspend transactions deemed to be abusive.
WHAT'S THE LIKELY NEXT MOVE?
EU finance ministers are not expected to agree an immediate ban on naked selling. The Commission will likely be asked to study the market and make recommendations, such as reporting of naked positions, as is being done for short selling of shares.
Ministers are likely to repeat the need for central clearing, reporting of CDS transactions to improve transparency.
Central clearing is already a G20 pledge to be implemented for all types of derivatives by the end of 2012. Clearing of some CDS contracts in the EU began in July last year.
A planned draft EU law on derivatives due mid-summer, will implement this pledge, along with reporting and tougher capital charges for uncleared derivatives trades.
(Reporting by Huw Jones; Editing by Susan Fenton)