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Merkel and Sarkozy’s Bid for Haste Risks Derivatives Strife

11 June 2010 04:32 (UTC +04:00)

Baku-APA. How the world has changed. As they made clear in their letter this week urging the European Commission to speed up action to regulate financial markets, Angela Merkel and Nicolas Sarkozy have views about naked credit-default swaps and short-selling of stocks, AAP reports quoting The Wall Street Journal.
These are subjects, one suspects, about which the German and French leaders were blissfully unaware a couple of years ago. Post the euro-zone debt crisis, no European politician worth his or her salt can be without a view on naked CDS.
For the uninitiated, CDS are a sort of insurance that pays out the holder if bonds default. Naked CDS indicate the holder of the insurance doesn’t own the bonds he’s insuring. The two leaders, and others, blame them for worsening the euro crisis, though the evidence for it is weak. Uncovered short-selling is selling of financial instruments you don’t own. Both are used by "speculators" who in popular political rhetoric are ganging up on the euro zone.
Despite the topicality of the subject, the letter’s timing struck some in Brussels as strange. After all, EU finance ministers signed off just this week on the commission’s work program for financial regulation, including the timing of their proposed regulations on short-selling, derivatives and CDS.
It’s possible the importance of the letter was mainly that it was sent. A meeting of the two leaders planned this week was canceled at short notice, generating lots of comment about how the two leaders, poles apart in terms of personality, don’t get on. Yet, for some, the subject over which they chose to show their solidarity was, given the scale of the challenges facing members of the common currency, trivial.
Whatever the motive, the letter increases pressure on the commission to be seen to be taking decisive action.
Many in the French press saw it as thinly veiled criticism that the commission is moving too slowly. Publicly, the executive interpreted it as an endorsement of its efforts. "We welcome the sense of urgency expressed by Paris and Berlin and the importance they attach to a coordinated European approach," said a spokeswoman.
She did, however, deliver what seemed to be a dig at its authors, after Germany’s recent unilateral moves to ban naked short-selling, criticized by, among others, French finance minister Christine Lagarde. "On short-selling, we have seen in recent weeks divergent positions of member states," she said. "We need a coherent European approach on this issue, which is what the commission is striving for."
But such political pressure is a two-edged sword. On one hand, officials often say it’s only when leaders intervene that anything gets done in international organizationsâ€”or at least gets done quickly. And if things don’t get done quickly, important initiatives often lose momentum.
On the other hand, heavyweight political intervention in technical matters doesn’t always help achieve rapid results. For example, in the technical discussions held by the Financial Stability Board and the Basel Committee on financial and banking regulations, some participants say the strong political positions adopted by various leaders are slowing down the work by making compromises even harder. President Sarkozy, for example, has a strong public position on matters that would once have interested only accountants, like mark-to-market accounting. (He’s not a fan.)
Some people at the commission see another downside in the intense political pressure to move rapidly to write new financial regulation: Legislation hurriedly drafted often turns out to be badly drafted. Exhibit A is the Alternative Investment Fund Management directiveâ€”meant to regulate hedge funds, private equity and the likeâ€”that was cobbled together in weeks last year under pressure from Paris and elsewhere.
That proposal was the subject of nearly 2,000 amendments from two committees in the European Parliament, and widely different versions have been agreed by the parliament and by the governments in European Council, that will have to be resolved before it becomes law. It’s not a great precedent.
"We have to find a balance between doing things properly and doing things quickly," says one commission official.
The derivatives legislation is, if anything, trickier than the AIFM directive. Again it’s the first time the EU has ventured into the area; many different national legislative frameworks are in place; and the issues are more complex.
Documents to emerge from the commission in the coming days will provide the basis for consultation, indicating in some areas the direction of the commission’s thinking. According to people who have seen late drafts, the commission will point out that short-selling has a valuable role in increasing liquidity, in price discovery and in hedging. Despite the pressure from the two leaders, it is unlikely to propose a ban on naked CDS, not least because of the practical difficulties of doing so.
It will pose questions related to how long naked short-selling positions should be kept open and what mechanisms might be used to suspend short-selling at a European level. It will look at how to increase transparency about short-selling and to reduce the risks associated with it.
The commission is aiming to have concrete proposals emerge in the summer on this and the rest of the derivatives legislation, and have it all passed into law by September. That, many might think, is already an ambitious enough target.