European finance ministers on Tuesday reached an uneasy compromise on restricting naked short-selling, a trade in which investors sell stocks or bonds they don't own and which some blame for worsening the global financial crisis.
The deal, however, does not include a ban on naked short-selling of credit default swaps for government bonds, as demanded by the European Parliament and Germany. A credit default swap, or CDS, is a kind of insurance that protects investors against a default on a bond.
The deal was reached after heated discussions among finance ministers, with some — like Germany — pushing for stricter rules, while others — led by the United Kingdom — warned that too much regulation could hurt financial markets.
The ministers now head into discussions with the European Parliament, which has already taken a much tougher position on such trades.
Tuesday's compromise shows the difficulty European politicians face in reforming markets after the global financial crisis, when some countries blamed short-selling for exacerbating market turbulence.
In a traditional short-sale, an investor hopes to profit by borrowing a share or bond, selling it and then buying it back at a lower price. In a naked short sale an investor bets on a drop in the price without actually borrowing the underlying share — a practice some regulators say can force asset prices to drop.
The ministers said Tuesday that investors must have a reasonable expectation of quickly obtaining the underlying asset when engaging in a short-sale. That leaves investors more leeway than the position of the Parliament, which said traders must be able to obtain the asset within one working day.
On top of that, states can request that the restrictions on naked short selling of their government bonds be temporarily removed when they fear that it limits liquidity in the market.
Germany dropped its demand to also include a strict ban on uncovered trading in CDS for sovereign debt. However, Deputy Finance Minister Joerg Asmussen said he hoped that the ban on naked CDS trades would come up again in the course of the discussions.
Germany and some other countries unilaterally banned the short-selling of sovereign CDS at the height of the debt crisis last spring, saying that speculators like hedge funds and investment banks were deliberately pushing down the price of Greek government bonds in the hope to make an easy profit.
The hedge fund industry insists that there is no clear evidence between uncovered trades in sovereign CDS and bond prices, saying that prices dropped because of normal market.
Andrew Baker, CEO of the Alternative Investment Management Association, a hedge fund industry association, welcomed Tuesday's decisions to refrain from banning the use of uncovered sovereign CDS.
"The Council's stance bears out the fact that such a ban could push up government borrowing costs," Baker said.
Gabriele Steinhauser can be reached at http://twitter.com/gksteinhauser.