Credit default swaps on EU sovereign debt are also covered by the EU’s new short selling regulation, which will come into force across the EU on Nov. 1, 2012. The Regulation prohibits uncovered or “naked” shorting of EU listed securities and CDS on EU sovereign debt. However, ESMA recognizes that a wide range of risks could be eligible for hedging through a sovereign CDS position and has stated that it believes that the most flexible approach would be for it to prepare a set of conditions, which would need to be met in order for an uncovered sovereign CDS position to be permissible as a bona fide hedge. [A further paper with ESMA’s guidance on these points is expected in mid-April.]
In general, persons who enter into CDS transactions in relation to EU sovereign debt will be required to make a disclosure to the relevant EU regulator, although the specific disclosure threshold has not yet been confirmed. As with short positions in relation to EU securities, the Regulation will also include a prohibition on uncovered or “naked” short sales and uncovered CDS, with the introduction of a new “locate rule” so that persons shorting securities or entering into sovereign CDS will be required to have located the relevant underlying assets before entering into the transaction. However, an exemption from the locate rule for sovereign debt CDS will be available where a person has assets or liabilities whose value is correlated with the sovereign debt and where the CDS is therefore a bona fide hedge. ESMA has recently provided draft advice on the Regulation, part of which clarifies when a sovereign CDS transaction is considered to be hedging against a default risk or the risk of a decline in the value of the sovereign debt — meaning that it is not an uncovered CDS position. To qualify, a sovereign CDS position must meet the following conditions:
- It must serve to hedge against either or both risk of default and risk of a decline in value;
- There must be a consistent significant correlation between the value of the asset or liability being hedged and the value of the sovereign debt referenced;
- A sovereign CDS position referencing an EU country may be used to hedge any assets or liabilities meeting the correlation test above – provided that the obligor of (or counterparty to) the asset or liability is located in the same EU country as the country referenced for the CDS; and
- The CDS position must be proportionate to the risks it is hedging.
Further clarification is expected from ESMA in mid-April, when it will publish its next guidance paper on the new rules.