The European Union agreed Tuesday to more strictly regulate the short selling of shares and bonds and to ban so-called "naked" credit default swaps on government bonds, moves officials said will contribute to financial stability.
After long discussions, representatives of the European Parliament and EU member states reached a compromise on the new rules, which restrict practices critics say have exacerbated financial crises and market selloffs.
The regulation seeks to differentiate between investors who use short-sales as a legitimate tool to hedge, or insure, potential losses on other assets like shares or bonds, and speculators, who may be trying to make a profit by influencing market moves.
The rules, which are expected to get final approval from the full European Parliament and EU finance ministers over the coming weeks, will come into force on Nov. 1, 2012.
Today's agreement by the European Parliament and member states "represents a significant step towards greater transparency, stability and responsibility in short selling transactions," said EU Internal Markets Commissioner Michel Barnier.
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 asset or having a legitimate exposure to the asset that he needs to hedge.
"Naked" short sales of shares and bonds will no longer be allowed under the new rules, unless the investor has a "reasonable expectation" that he will be able to borrow the shares or bonds in time.
Most analysts agree that in most cases, regular short-sales allow investors to hedge risk and improve liquidity in markets. However, investors will have to inform regulators of large short positions, so they can more easily spot potential risks, such as downward price spirals.
The parliament reached a significant victory in posing a ban on buying credit default swaps on government bonds if the investor doesn't actually own bonds from that country or assets whose value could be hurt by a default. A credit default swap, or CDS, is a kind of insurance that protects investors against a default on a bond.
During the eurozone debt crisis, several politicians blamed speculation in CDS on sovereign debt for driving down bond prices and pushing up interest rates.
National regulators have the right to opt out of the ban, if they believe that it restricts liquidity in their bond markets.
But representatives of the hedge fund industry immediately came out against the new rules.
"We have previously expressed our concerns about the impact of a ban on uncovered sovereign CDS", said Andrew Baker, CEO of the Alternative Investment Management Association. "It could not only reduce liquidity and increase volatility in debt markets, but also increase government borrowing costs and reduce real economy investments in EU member states."
The newly created European Securities Markets Authority will also have more powers in coordinating short-selling bans and flagging risks. At the high of the financial crisis of 2008, several national regulators announced bans on short-selling without informing their counterparts in other member states.