Short-selling and CDS regulation in EU: Less to nakedness than meets the eye, funds and firms argue

March 5, 2012

By Peter Elstob

LONDON/NEW YORK, March 5 (Thomson Reuters Accelus) – Regulators and market participants continue to differ fundamentally over when a credit default swap should be deemed to be uncovered, or ‘naked’, and when investors are using CDS as a legitimate hedge. If a sovereign CDS can be demonstrated to be hedging counterparty or systemic risk, it can be exempted from the provisions of the proposed European short-selling regulation, which is aimed at abusive use of sovereign CDS by financial institutions to bet against countries’ debt.

Trade bodies argue that regulators should recognize various forms of ‘proxy’ hedging, including buying CDS for the debt of countries other than the one where the institution’s exposure lies — so-called ‘cross-border’ hedging’ — and ‘tail-risk’ hedges that may or may not turn out to have been necessary over a given period. They believe that the short-selling regulation (level 1) does not ban these strategies, and they should therefore be permitted (and so qualify for exemptions) in the detailed rules (level 2) that the European Securities and Markets Authority (ESMA) is still drawing up.
These level two rules come in two varieties: draft technical standards and drafts of ‘delegated acts’, essentially a legal device whereby ESMA and the other European supervisory authorities are able to write rules, which the European Commission adopts without needing to put them completely through the legislative process.

In its draft delegated acts for the short-selling regulation, ESMA said that a primary condition a sovereign CDS must meet if it is not to be deemed to be uncovered is “a consistent significant positive correlation between the value of the asset/liability being hedged and the value of the referenced sovereign debt”. But at a public hearing at its Paris headquarters last week, ESMA told industry representatives that proxy hedging strategies, including hedging across the European Union’s internal borders, failed the correlation test, and so would be excluded from the exemptions in the regulation.


One of the four regulators holding the hearing, Dilwyn Griffiths, a senior official at the Financial Services Authority (FSA), said ESMA’s essential principle was that the risk being hedged should be in the same member state as the referenced sovereign debt. That was what was in the regulation, and the European Parliament and Council would expect it to be reflected in ESMA’s rulebook, said Griffiths, who is a co-head of the ESMA task force on the short-selling regulation. “There’s no point in ESMA preparing advice on an issue which is not going to be taken,” he told the industry representatives. “We are not the final arbiters in this area.”

As well as ‘correlation’, the other main criterion for demonstrating that a CDS is being used for genuine hedging is ‘proportionality'; in other words, that the size of the CDS position is reasonably proportionate to the assets or liabilities it hedging.

“As regards proportionality, we recognize that a perfectly proportionate position may not be possible to achieve, at least consistently, especially when valuations are subject to change, because of market movements,” Griffiths told the hearing. “But we have set down the principle that where matters are within the position-holder’s control, the sovereign CDS position must remain proportionate to the value of the risk or liability that it’s hedging. So if you have a portfolio and you start to liquidate elements of the portfolio, you can’t go on just holding the same sovereign CDS version.”

Representatives from a number of trade bodies and individual financial institutions argued against excluding proxy and tail-risk hedging strategies from the exemptions in the final rulebook, and they also questioned the view that these were prohibited by the level one regulation


Leonard Ng, a partner at Sidley Austin LLP, who was speaking on behalf of the Managed Funds Association, the global hedge funds trade body, made the point that most hedge fund managers run a fully hedged book overall, and so regulators would need to look at portfolios as a whole, and if fund managers were buying significantly more protection than their exposure necessitated, regulators would obviously be entitled to ask questions. Ng challenged the idea that cross-border hedging was excluded from exemption in the regulation, and he highlighted why such a strategy might make sense, for example using Greek sovereign CDS partly to hedge against exposure to French banks holding plenty of Greek debt, or buying CDS for Danish sovereign debt as a highly correlated but much cheaper proxy for German debt.

Ng also raised the issue of forward-looking ‘tail-risk’ hedging, which he described as “a sort of anticipated correlation”. He told the regulators: “[Fund managers] don’t hedge in the obvious way, but when you take the whole portfolio … you can see what’s going on … We would say that it is more important for each [hedge fund manager] to demonstrate that it’s acting in accordance with certain investment objectives and strategies which can be demonstrated to the regulator.”

ESMA proposed that firms should back up their demonstrations that the hedging was correlated with historical trading data going back 12 months, but Ng and others argued that the final rules should not include a specified timeframe.

“I think the 12-month period isn’t helpful when … you’re looking at anticipated correlation, you’re not looking at past correlation, so it’s actually very difficult to show,” Ng said. The regulator should sit down with investors and require them to demonstrate how they had actually been hedging, rather than simply looking at a simple numerical test going backwards. “Statistical correlation, I think, in this context, is actually extremely difficult to show,” he said.

Other participants at the hearing backed up Ng. Adrian Hood, regulatory adviser at the Investment Management Association, said there were many examples where cross-border hedging was both proportionate clearly correlated. “It’s a most efficient and effect way of hedging, and allowing people to invest into countries, and having an impact on the real economy,” Hood told the regulators.

Julia Rodkiewicz, a policy manager in the European regulatory team at the International Swaps and Derivatives Association (ISDA), said excluding cross-border hedging from exemption risked disincentivizing investors from cross-border business. ISDA’s own legal advice, said Rodkiewicz, was that cross-country hedging was not excluded from the derogation, but was, rather, an essential element of the regulation.


Konstantinos Botopoulos, chairman of the Greek capital markets regulator, and a member of ESMA’s board of supervisors, who chaired the hearing, conceded that it was not entirely clear from the wording of the regulation whether cross-border hedging was exempted or not. But he warned the industry representatives, ESMA had received “a very strong position” from the commission’s legal services that it was not exempted. Botopoulos was unsure whether this view was an official written legal opinion from the commission: “but that’s what they’ve told us in the conversations we’ve had.” He added that this strong view on the part of the commission did not preclude ESMA proposing something different, but it needed to be taken into account.

Ng said that it was very hard for him, as a lawyer, to see where the regulation prohibits cross-border hedging, and he said he would “very interested” in the commission’s view.

Michael Collins, managing director, European government affairs at Citibank, agreed: “If this advice from the commission’s legal service is so definitive, and so clear, I think it would be extremely helpful to all of us, in commenting on ESMA’s draft delegated acts, and the questions set out in the consultation paper, to see that legal advice,” Collins said. “Because I think there’s a very strong difference of opinion from many lawyers from our side of the table.”

Griffiths stressed that ESMA’s short-selling rulebook would be as broad as possible, and would cover dynamic risks, such as credit valuation adjustments (CVAs), as well as static risks such as holdings in bank debt, and that being in the form of delegated acts, the proposed rules were able to include an illustrative, rather than an exhaustive, list of cases that would be eligible to be hedged by CDS. Given the wide variety of assets able to be hedged, the rules would also frame the correlation test in general, not overly-precise terms, he said. Moreover, ESMA had proposed what was essentially a carve-out for ‘involuntary’ uncovered CDS positions, obtained as a result of clearing obligations. In relation to cross-border and other proxy hedging, however, Griffiths warned the industry representatives: “We can’t re-write the level one text.”

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.  Compliance Complete ( ions/regulatory-intelligence/compliance- complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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