Credit Default Swaps and Selling Written evidence

Memorandum by Bank of America Lynch (CDS 1) ...... 1 Memorandum by Mr John Chapman, former Civil Servant and Journalist (CDS 2) ...... 4 Letter from the Investment Management Association (CDS 3) ...... 10 Letter from the Association for Financial Markets in Europe (AFME), International Securities and Lending Association (ISLA) and International Swaps and Derivatives Association (ISDA) (CDS 4) .... 13

Memorandum by Bank of America Merrill Lynch (CDS 1)

1. How much short selling is there in the sovereign bonds markets? Does this have a significant influence on sovereign bonds?

2. There is no way to measure how much occurs in the market. We as market makers and primary dealers in the sovereign bond market are committed to providing bid and offer prices in which counterparties may purchase or sell against us. When accepting a sale trade we have no way of knowing if this takes the client short. From a proprietary perspective we may find ourselves taking a short but for settlement purposes these are covered by reverse repo after the fact.

3. The ability to trade into a short position is integral to providing liquidity and is a hedging tool to manage risk.

4. What are the risks of naked short sales of sovereign bonds?

5. Naked short selling on the sovereign bond market does not increase risk. Short positions are generally easily covered for settlement as a result of a highly liquid repo market in sovereign bonds.

6. Do credit default swaps (CDSs), both covered and naked, have a significant impact on the price of the underlying sovereign bonds?

7. We do not believe that CDSs have a significant impact on the price of related sovereign bonds. Data available from DTCC (The Depository Trust and Clearing Corporation) shows that sovereign CDS nationals are around 2-3% of applicable outstanding sovereign debt. Such data also shows that there is no correlation between market volume of sovereign CDS and either CDS or bond spreads. It is very hard to believe therefore that CDS significantly impact the price of the related bonds. Rather, the position is the converse.

8. Under what circumstances could CDSs have adverse consequences for the sovereign bond markets? 9. It would not appear that CDS markets of the size and characteristics seen to date have any significant adverse consequences for the sovereign bond markets.

10. Could CDSs contribute to a contagion effect where healthy economies suffer higher borrowing costs?

11. On the contrary, the risk mitigation functions of CDS lead to greater liquidity and a lowering of borrowing costs.

12. Can the use of naked CDSs increase the costs of borrowing? Could naked CDSs contribute to a default by a sovereign government on bonds?

13. As stated above, we consider that the risk mitigation functions of CDS lead to greater liquidity and a lowering of borrowing costs. Whilst it would be theoretically possible for rampant and explosion of the CDS market to have an effect on the cost of borrowing, we have seen no evidence of this in the markets to date. Even if that event happened, it would be a symptom and not the cause of the issue. A sovereign default would be caused by far more serious underlying issues of over borrowing and lack of revenues, the markets would merely be reflecting those underlying concerns.

14. Could EU restrictions on CDSs or naked CDSs have a negative impact on sovereign bond markets across the EU, and on the sovereign cost of borrowing?

15. Yes they could. CDSs are a valuable risk management tool both in respect of a long position in the sovereign debt itself and in respect of exposure to the debt of that state’s banks and corporates. The ability of sovereigns and banks to borrow relies on sufficient investor demand. If investors were prevented from hedging their positions, there would be greater uncertainty involved in holding the debt and fewer investors in the market, leading to lower liquidity and increased borrowing costs.

16. How can the impact of any temporary restrictions or ban on short selling or CDSs be balanced against the benefit which such restrictions could bring in terms of reducing the risk of negative price spirals in distressed markets?

17. We would challenge the assertion that such restrictions reduce the risk of negative price spirals. Rather we would argue that the ability to use CDS to hedge positions could result in investors retaining their exposures. Without the ability to hedge, investors would be inclined to sell, exacerbating the negative price spirals.

18. Could a restriction on CDSs be justified if a country’s cost of borrowing can rise due to CDS price hikes that are unrelated to a country’s credit-worthiness?

19. As stated above, we would contend that CDS pricing is keyed off a country’s cost of borrowing and not vice versa.

20. Should a ban of naked CDSs be introduced at an EU level? Why?

2 21. Evidence does not warrant a ban on short-selling or CDS in circumstances such as those seen in the markets to date.

22. Care needs to be taken to avoid unintended consequences of bans on short selling and CDS. We have a particular concern in relation to the interplay between the Regulation on short selling and the Regulation on OTC derivatives which has the agenda of mandating clearing of suitable derivatives contracts. There is a danger that a move to prevent short selling and naked CDS in relation to sovereign debt may result in a threat to the stability of clearing houses by interfering with their default management process, thereby causing systemic risk. Restrictions would make it more difficult for any other clearing members to bid to take on risk in a clearing house auction process as they would potentially compromise the ability to hedge the resulting portfolio. The margin collected at the clearing house to cover those positions would need to be increased as compared to that taken in circumstances where no restrictions existed. This would lead to higher costs of trading for the industry.

23. Much of the increased activity in sovereign CDS seen at recent times of crisis in the sovereign debt markets can be attributed to hedging activity as sovereigns’ credit deteriorated. This constituted risk mitigation both specifically, in relation to large uncollateralised exposures faced by banks to sovereigns themselves, and generally, in respect of exposures to the relevant country’s corporates and banks. The prevention of naked CDS would prevent this latter, general risk management Preventing general risk management by banks in the financial system arguably increases the instability of the banking system, and does not reduce it.

24. What would be the pros and cons of enabling EU supervisors in certain circumstances, rather than national authorities, to have the power to temporarily restrict or ban short-selling and CDSs in emergency situations?

25. No response

26. Could such a temporary ban of CDSs and short-selling be easily circumvented by market operators?

27. No response

28. General Matters

29. We attach, for your information, a copy of our position paper1 as to the proposed Regulation on Short Selling and Certain Aspects of Credit Default Swaps.

1 For a copy please contact the Clerk of the Sub‐Committee.

3 Memorandum by Mr John Chapman, former Civil Servant and Journalist (CDS 2)

1.1 I welcome this opportunity to comment on the proposed regulation, and to respond to the questions put forward by the Committee.

1.2 The regulation addresses the systemic risks of short selling, as revealed in the biggest financial crisis and economic retreat in living memory. It also provides a necessary defence, as speculators shift their attacks from banks to sovereign bonds.

1.3 But this regulation must only be a first step. The EU Commission must do much more to curb the casino capitalism that has emerged over the last 25 years, looking at:-

- the extraordinary growth of short selling, from very low levels in 1995 to 30% or even 40% of market activity; - the amoral aspect of widespread gambling against companies or countries; - the domination of short selling by the Reagan-created elite, still led by rich individuals; - the unfair trading advantages of hedge funds, notably the ability to short; - the exploitation by hedge funds of traditional investors in a zero-sum situation; - the perverse practice of lending securities to lose value through shorting; - the contempt for quoted companies who may be shorted; - the affront to democracy by the shorting of sovereign bonds by the duo of hedge funds and Wall Street investment banks. - Particular questions raised by the Committee

2.1 The EU Commission has created a defence through notification levels of short holdings of shares or net short positions on sovereign bonds (including CDSs), restraints on naked short selling, exceptional circuit breakers, and actions by individual member states or co- ordinated action by the European Securities Markets Authority (ESMA) in exceptional situations. The Committee has raised the following questions.

2.2 Q1 How much short selling is there in the sovereign bonds markets? Does this have a significant influence on sovereign bonds? What are the risks of naked short sales of sovereign bonds?

2.3 Reports from the New York Times and Reuters indicated short selling of Greek bonds in February this year, and similar action against Irish bonds in November. Data Explorers was the source. Action against Greek bonds was accompanied by purchases of CDSs, which were significant earlier in 2009. The yield on 10 year Greek bonds apparently rose from 5% at end November 2009 to 6.5% in mid-February 2010.

2.4 But CDSs may be the favoured route for shorting sovereign bonds. For example, one academic paper (1) discusses shorting mainly in terms of CDSs and CDS spreads.

4 2.5 As for naked short sales, the EU Commission asked a similar question in its June consultation paper. The UK indicated that there was no evidence of manipulative short selling of bonds, etc. The German Federal Ministry of Finance responded that although there was no evidence of such risks, they could be the same as those pertaining to shares. The French Ministry for the Economy, Industry and Employment considered that there were potential risks, and there should be no exemption. My own view is that if other means of shorting, eg naked CDSs, were blocked, naked short sales could emerge.

2.6 Q2 Do CDSs, both covered and naked, have a significant impact on the price of the underlying sovereign bonds? Under what circumstances could CDSs have adverse consequences for the sovereign bond markets? Could CDSs contribute to a contagion effect where healthy economies suffer higher borrowing costs?

2.7 CDS spreads and prices of sovereign bonds should move in line, though academic studies differ on the issue of which leads, and “dislocations” have been found. A study of the pre- crisis period suggests that the relationship of sovereign CDSs and bond markets has strengthened over time, and that bond markets then led in price discovery (2).

2.8 In contrast, studies of the post-2007 period indicate CDSs may lead. For countries such as Portugal, Spain and Ireland, the CDS market exhibited a growing influence on bond yields post 2009 (3). In another study, countries were divided into three panels according to their average CDS premia. The first sample was made up of “stronger” W European countries (eg Netherlands) with low CDS spreads, and here bond spreads hardly adjusted to CDS spreads. For the second group (the PIIGS countries) with higher spreads, the reverse was true, with the CDS market ahead of the bond market. For the third group (emerging countries) the CDS market was even further ahead. The results also highlighted that the CDS market’s lead had been exacerbated by the financial turmoil in Southern Europe (4).

2.9 CDS speculation can then have adverse consequences for sovereign bond markets where countries have been weakened by the crisis. Countries with the highest government deficits as a % of GDP include Greece (15.4%), Ireland (14.4%),. United Kingdom (11.4%), Spain (11.1%), and Portugal (9.3%) (5). In its latest Financial Stability Report, the IMF points to heightened concerns about risk transfers between banks and the sovereign, not least where there has been official support for the banks (6). Short selling through CDS speculation currently focuses on sovereign bonds of weaker EU countries, or on the euro.

2.10 The IMF report also refers to euro and sovereign debt strains spilling over into central and east European countries because of their high dependence on exports to the euro area – an illustration of the contagion effect that CDSs could cause.

2.11 Q3 Can the use of naked CDSs increase the costs of borrowing? Could naked CDSs contribute to a default by a sovereign government on bonds? The answers to both questions must be yes.

5 2.12 Q4 Could EU restrictions on CDSs or naked CDSs have a negative impact on sovereign bond markets across the EU, and on the sovereign cost of borrowing?

2.13 Such restrictions would remove the main route of shorting sovereign bonds, thereby making them less vulnerable to the uncertain effects of speculation, and less likely to face higher borrowing costs. But in such circumstances new ways of shorting like naked short sales might be used unless they were also restricted.

2.14 Q5 How can the impact of any temporary restrictions or ban on short selling or CDSs be balanced against the benefit such restrictions could bring in terms of reducing the risk of negative price spirals in distressed markets?

2.15 There have been many studies of the effects of almost world-wide restrictions on short selling in response to the crisis. Any costs, like higher spreads, have to weighed against the benefits of containing the crisis – a subjective judgment.

2.16 Q6 Could a restriction on CDSs be justified if a country’s cost of borrowing can rise due to CDS price hikes that are unrelated to a country’s credit- worthiness? The answer must be yes, if the necessary situations arose.

2.17 Q7 Should a ban on naked CDSs be introduced at an EU level? Why?

2.18 Many esteemed commentators are critical of naked CDSs. H-W.Sinn of the University of Munich comments “Truly perverse is the opportunity to insure, by means of a CDS, against the bankruptcy of another firm, even though this bankruptcy does not inflict any damage on the insurance purchaser” (7). The President of the Bank of America has referred to the “abuse” of CDSs “While originally used as counterparty insurance, CDSs became a highly efficient way to short” (8).

2.19 George Soros has explained that with CDSs the risk/reward asymmetry works in the opposite way to that in normal shorting. Going short on bonds by buying a CDS carries limited risk but almost unlimited profit potential. This asymmetry encourages speculating on the short side, which in turn exercises a downward pressure on the underlying bonds. Soros considered that AIG, , and were destroyed by bear raids in which the shorting of and buying CDS mutually amplified and reinforced each other. He considered that CDSs were toxic, and should only be used by those who own the bonds, not by others who want to speculate against countries or companies (9).

2.20 Wolfgang Munchau of the Financial Times wrote that naked CDSs were the instruments of choice for those who take large bets against European governments. They were speculative gambles, without social or economic benefit, and should be banned (10)

2.21 A ban on naked CDSs would be a much-needed step against casino capitalism. A ban at the EU level would rule out regulatory , and show the political unity necessary to make the step effective.

6 2.22 Q8 – re action by EU supervisors, see para 3.16.

More work for the EU Commission – the need to curb casino capitalism

3.1 The proposed regulation should be seen as a starting point in a drive to curb the casino capitalism that has spawned over the last 20 years – an amoral, elitist, unfair, exploitative, perverse, contemptuous and undemocratic form of capitalism.

The spectacular but stealthy growth of short selling

3.2 Over the 50 years to 1995 the number of shares sold short each year was steady at under 10 billion a year. But from 1995 short selling took off, with the number of shares sold short rising to 55 billion by 2007 (11). Consultants Oliver Wyman have commented that “Many market observers do not appreciate the magnitude of short selling. Some estimates have short sellers responsible for between 20-30% of equity trading volume (12). Academics have estimated shorting activity as high as 40% in recent years (13)

The amoral aims of short selling

3.3 Debates over short selling usually pitch claims of greater liquidity, price discovery, prevention of bubbles and use in hedging against possible drawbacks of depressed prices, price manipulation, systemic risks and fails to deliver. But such arguments shrink from the main issue – the lack of morality in betting through short sales or CDSs on the decline or even downfall of a company or country.

Short selling the domain of the hedge fund elite

3.4 Short selling is very largely carried out by hedge funds, whose rapid growth to some $2 trillion stems from a Reagan administration ruling that millionaires, those earning over $200,000 a year, and certain institutions should be exempt from regulation. Rich individuals remain the largest group of hedge fund investors (14).

The unfair trading advantages of hedge funds – notably shorting

3.5 Hedge funds have several trading advantages over traditional funds, including unrestricted leverage and use of derivatives, illiquidity and other operational features, and the priceless ability to short. Short selling is a key component of most hedge fund strategies, and lies behind the out-performance of hedge funds.

3.6 Over 1999-2009, the hedge fund composite index achieved an average net return of 9% pa compared with 0% by traditional funds in the US market. But in the 7 years when markets rose both net returns were around 15% pa. But in the 4 years when markets fell, hedge fund returns averaged minus 3% pa, compared with minus 22% for traditional funds – a 19% pa out-performance resulting from the hedge funds ability to short (15).

The $100 billion a year exploitation of traditional funds

7 3.7 As I have pointed out in a Financial Times article, if hedge funds win the zero-sum battle for alpha (out-performance through skill-based investing, or through other advantages), then traditional funds must lose equivalent amounts. Over 1999-2009 the gains of the $2 trillion hedge funds may have averaged $100 billion a year, matched by losses of $100 billion a year incurred by the $65 trillion traditional funds, i.e. pension funds, insurance funds and mutual funds (16).

The perverse and hidden practice of

3.8 In order to carry out shorting on the now very large scale, hedge funds must borrow substantial amounts of shares, bonds, etc for shorting. Astonishingly, pension funds, mutual funds and others lend securities (at a fee) to hedge funds, even though they must realise that the funds will be shorted and probably returned at a lower price.

3.9 Although the securities lending industry world-wide amounts to $2 trillion, little is heard of it. Chairman Schapiro of the SEC has described the industry as “opaque”, as its operations, including the sharing of lending fees between intermediaries, fund managers and the lending funds, are little publicised. The industry could also be described as “hidden”, as few investors are aware of it or of its (perverse) operations.

A contempt for the companies in the market

3.10 Short sellers can have little regard for the companies they are betting against, even though such companies provide investment and employment for the wider community. A 2008 survey of NYSE/NASDAQ companies indicated that 73% of CEOs thought short selling was harmful to their company’s stock and shareholders, with the proportion higher in companies with lower market caps.

3.11 Of the 113 respondents to the EU Commission’s consultation on the regulation, only a handful were not involved in short selling. The Federation of German Industries suggested that the views of companies and investors should also be considered seriously. The Federation of Swedish Enterprise refused to comment without a deeper analysis of effects on companies, including the ability to raise capital. .

Wall Street investment banks and hedge funds versus governments and the ECB

3.12 Short selling of sovereign bonds and attacks on the euro boil down to a battle between hedge funds and their partners in arms, the Wall Street investment banks, against governments and their supporters, notably the ECB. That the financial elite can take on elected governments is a poor advertisement for democracy.

The ambiguous position of UK governments

3.13 In principle governments should exhort the EU Commission towards a ban on naked CDSs, and to further work and proposals to curb or even close down casino capitalism, with a possible phasing out of short selling and hedge funds (as I have already suggested, see 17).

8 But the UK hosts the bulk of hedge fund managers outside the US, and such managers provide tax revenue and employment.

3.14 UK governments have then to decide whether to block further curbs on the casino capitalism of its paying guests, or to support a drive to bringing markets back to a state where the well-being of quoted companies and even countries is of more importance than that of speculators.

Bibliography

1 – Is there a case for banning short speculation in sovereign bond markets? Darrell Duffie, Stanford University, Banque de France, July 2010 2 – The Dynamics of Sovereign Credit Default Swaps and Bond Markets: Empirical Evidence from the 2001-2007 period, E Aktug, E Vascorellos, Y Bae, Lehigh University 3 – Liquidity Interaction in Credit Markets: A preliminary Analysis of the Eurozone Debt Crisis, G Calice, J Chen, J Williams, October 2010 4 – Credit Default Swaps and bond markets – Which leads the other? V Coudert and M Gex, Banque De France, July 2010 5 – The Guardian, I December, 2010 6 – IMF Financial Stability Report, October 2010 7 – Casino Capitalism, H-W Sinn, University of Munich, 2010 8 – Brian T Moynihan, CEO and President, Bank of America, 2009 9 – George Soros, Wall Street Journal, 24 March 2009 10 – Wolfgang Munchau, Financial Times, 28 February 2010 11 – Short Selling, Deutsche Bank Research, March 2010 12 – The effects of short selling public disclosure regimes on equity markets, Oliver Wyman, 2010 13 – What do short sellers know? E Boehmer, C Jones, X Zhang, September 2010 14 – From Black Box to Open Book; Hedge Fund Trust and Transparency, PwC, 2010 15 – John Chapman using data from EDHEC, Hennessee, Aon Consulting and S&P 16 – The real losers in the battle for alpha, John Chapman, Financial Times, 23/8/2010 17 – Phasing Out Hedge Funds, John Chapman, Public Policy Research, 2010.

December 2010

9 Letter from the Investment Management Association (CDS 3)

The IMA represents the asset management industry operating in the UK. Our Members include independent fund managers, the investment arms of retail banks, life insurers and investment banks, and the managers of occupational pension schemes. They are responsible for the management of £3.4 trillion of assets, which are invested on behalf of clients globally. These include authorised investment funds, institutional funds (e.g. pensions and life funds), private client accounts and a wide range of pooled investment vehicles. The IMA's authoritative Asset Management Survey 2009-10 recorded that IMA member firms were managing 40% of the domestic equity market on behalf of clients.

I welcome the opportunity to comment on the proposals made in the paper. IMA fully supports efforts by the European Commission, and other regulators, to fight potentially abusive short selling practices that may have contributed to the destabilisation of the financial markets.

The European Commission paper identifies four potential problems with short selling:

• Potential negative price spiral in extreme market conditions; • market abuse; • transparency deficiencies around market orderliness and information asymmetry; and • settlement failures

The IMA argues that market disclosure is not necessary to resolve the potential problems, and could exacerbate some of the problems, when they do arise.

There is no evidence that short selling has exacerbated either negative price spirals, indeed most academic research indicates the opposite; there is no indication that short selling is involved in market failures, indeed the main regulated markets confirm that this is the case; and market abuse is dealt with adequately under the Market Abuse Directive, which the EU Commission is actively revising and expanding at the moment, so we see no reason why it should be shoe-horned into another parallel directive.

Public disclosure of short positions, which is the proposal’s main tool to tackle information asymmetry, could seriously harm: investment managers by exposing their proprietary positions to others; other investors who may attempt to mimic the disclosed investment strategy or use the information for their own benefit without cost and without understanding the implications; and the market, by reducing efficient price discovery, increasing volatility and spreads. Disclosure to the regulator should meet the problems identified. The blanket imposition of disclosure on short positions in all companies would damage the market, and so the prosperity of parts of the wider economy.

We would not be opposed to the aggregated, anonymised and suitably delayed reporting of gross short positions, to the market, should a suitable case for this be made.

10 We would note that the recent EU Commission Report, led by Jacques de Larosiere, which reviewed in depth the causes of the recent market difficulties, only referred to short selling once, when it stated that short-selling transactions mainly fulfilled a ‘transmission function’. The report did go on to recommend that the rules on short selling in the EU were made more consistent, but this was in the interest of market efficiency, not recommending any restrictions on short selling.

In the UK, the Turner Review noted, with respect to short selling restrictions, the importance of a regulator “adopting a philosophical approach which overtly balances the benefits of increased liquidity in markets with the danger that in specific markets at particular times, financial stability concerns may be more important” and that the regulator should only apply ‘special measures if needed’. All the evidence indicates that most of the time special measures are not needed: they only become necessary (and therefore justifiable) at times of instability.

We also note that our recommended approach on public disclosure is in line with our international peers in Australia (the IFSA) and the USA (the IAA and the ICI).

I look forward to hearing from you if there is any clarification that you would find useful on the points I have raised. I would be happy to discuss the thinking behind the market disclosure requirements

Q1: How much short selling is there in the sovereign bonds markets? Does this have a significant influence on sovereign bonds? What are the risks of naked short sales of sovereign bonds?

We are not aware of there being much, if any, short selling of sovereign bonds in normal market conditions.

Q2: Do credit default swaps (CDSs), both covered and naked, have a significant impact on the price of the underlying sovereign bonds? Under what circumstances could CDSs have adverse consequences for the sovereign bond markets? Could CDSs contribute to a contagion effect where healthy economies suffer higher borrowing costs?

No comment

Q3: Can the use of naked CDSs increase the costs of borrowing? Could naked CDSs contribute to a default by a sovereign government on bonds?

No comment

Q4: Could EU restrictions on CDSs or naked CDSs have a negative impact on sovereign bond markets across the EU, and on the sovereign cost of borrowing?

Yes, we believe that all the research on the effects of restricting short selling over the last decade indicates that the effect of imposing restrictions on the market’s ability to short sell,

11 with the concomitant loss of liquidity, has a much greater impact in increasing the costs of borrowing than would allowing short selling to continue unfettered. Research has shown that prices may actually be lower with short selling restrictions because investors demand a higher risk premium when restrictions are imposed (Yang Bai et al, 2006)

Q5: How can the impact of any temporary restrictions or ban on short selling or CDSs be balanced against the benefit which such restrictions could bring in terms of reducing the risk of negative price spirals in distressed markets?

The only way to limit the impact of such restrictions or bans is to keep them as short, and as focussed, as possible. They should only be imposed once more research has been conducted to determine when, if ever, such negative price spirals occur.

It remains unclear, to us, who would be able to determine, in advance, when such a temporary restriction should be applied, financial markets being inherently unpredictable.

Q6: Could a restriction on CDSs be justified if a country’s cost of borrowing can rise due to CDS price hikes that are unrelated to a country’s credit-worthiness?

If, which we do not believe, CDS price hikes were unrelated to a country’s credit- worthiness, then it may be worth considering whether any such restrictions on CDSs would be justified, or likely to be effective. However, asset managers would only use CDSs when they did have concerns about the credit-worthiness of the country concerned.

Q7: Should a ban of naked CDSs be introduced at an EU level? Why?

No. CDSs serve a useful function in the market, and many CDSs which would be considered, under the current paper from the EU Commission, to be ‘naked’ are taken out by asset management firms to cover risk to which they are exposed in the country concerned, even if they may not have long holdings in the precise underlying instruments.

Q8: What would be the pros and cons of enabling EU supervisors in certain circumstances, rather than national authorities, to have the power to temporarily restrict or ban short-selling and CDSs in emergency situations? Could such a temporary ban of CDSs and short-selling be easily circumvented by market operators?

We would not be in favour of empowering EU supervisors to have any more power over national markets than they already have. We are particularly concerned that the intervention powers which it is proposed, in the Short Selling and CDS paper from the EU Commission, should be given to ESMA are considerably more broad and unfettered than those that are proposed in the main ESMA regulation.

December 2010

12

Letter from the Association for Financial Markets in Europe (AFME), International Securities and Lending Association (ISLA) and International Swaps and Derivatives Association (ISDA) (CDS 4)

On behalf of our members, the Association for Financial Markets in Europe (“AFME”), the International Securities Lending Association (“ISLA”) and the International Swaps and Derivatives Association (“ISDA”) appreciate the opportunity to respond to your request for evidence regarding the proposed EU regulation on short selling. Firstly we would like to draw your attention to a paper we have written to help inform policymakers of our views (see ‘Short Selling Briefing Paper’2). This paper was submitted to the European Commission following publication of its draft regulation on September 15th and provides some commentary on the proposals.

In summary we believe strongly that short selling contributes significantly to the efficiency of the financial markets and believe that there is no evidence to support it having any real detrimental effect. The same is true of sovereign CDS activity. Some of the regulatory measures being discussed, in our opinion, have little value in addressing the risks perceived by policymakers and will simply serve to remove liquidity from the market. This in turn will add significant additional costs for all investors (such as pension funds and retail investors) and increase the cost of raising capital for corporate and even sovereign states in the primary markets.

Whilst it is commonly acknowledged that short selling serves a useful role in the financial markets, it is often overlooked that this investment activity also benefits society at large. When corporates can raise capital on more attractive terms it means that there is more potential to invest in growth and employment. When pension funds incur less costs transacting in the financial markets it means that investment returns are improved and individuals receive more security in retirement. Our second paper attached (see ‘Short Selling: Social Benefits’) provides a brief summary of how short selling benefits society more broadly.

One area that has not yet received enough attention concerns the proposed calls for public transparency of significant short positions in equities. We have fully supported the calls for private disclosure of short positions to regulators as we believe it is important for regulators to have visibility into this important part of the market. It has however been shown that requiring public transparency can harm the market and the attached paper (see ‘Equity Short Selling and Public Transparency’)3 provides more detail on this.

2 For a copy, contact the Clerk of the Sub‐Committee.

3 For a copy, contact the Clerk of the Sub‐Committee.

13 An issue that has, on the other hand, received a great deal of attention is that of naked sovereign CDS. We believe that any move to ban naked sovereign CDS positions would be misguided, and indeed harmful, given their importance as a risk management tool. Furthermore, there is no strong evidence to suggest that sovereign CDS activity influences prices in the underlying bond markets. The paper ‘Sovereign CDS’ provides more detail on this.4

We continue to engage with policymakers throughout Europe on the development of this important Regulation. We welcome your interest and would be pleased to provide you with more information should you wish. Finally we also include some other papers that provide more information on certain specific aspects of the proposed regulations (see ‘Uncovered Short Selling’, ‘Buy-in Proposals of Short Selling Regulations’, ‘Short Selling Exemption’).5 We hope that these are of help as you consider this issue further.

December 2010

4 For a copy, contact the Clerk of the Sub‐Committee.

5 For a copy, contact the Clerk of the Sub‐Committee.

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