28 May 2010

EZA 950 Report: GERMANY

• The ban on short selling of government bonds, financial stocks and naked CDS announced on 19 May is obviously not meant as a “stand alone measure” by the German government.
• On 25 May the German finance ministry in a press note indicated its intention to extend the short selling ban to all listed stocks and include these measures in a more general act on financial market regulation.
• Despite the fact that government concerns are recognised on a European and international level the tight deadline for German legislation implies that the government prioritises its own political agenda over sustainable regulation.

Short selling ban – from a one off measure to a systematic approach

When the German government announced its ban on short selling of selected financial stocks, on euro government bonds and naked CDS on 19May, initial market reaction reflected the confusion. The first intuitive reactions – such as pressure on the euro, stabilising stock markets and tightening of government bond spreads and CDS spreads - were reversed during the following trading day. Against this background it seems surprising that on 25 May the German finance ministry followed this move by an announcement of further measures to extend the short selling ban and provide a sound legal foundation. Interestingly the opposition SPD signalled its support for this endeavour.

Three immediate questions emerge

(1)   How effective are the measures?

The immediate effects have been limited, as seen in the reversal of initial market moves such as CDS tightening. The reasons being (a) trend-decrease in CDS activity; (b) low ratio of CDS hedging relative to the level of bonds held by German banks. According to DTCC figures, the volume of naked CDS relative to holding in government bonds of Italian, Spanish, Portuguese or Greek bonds was less than 5%. On the other hand the issuance of credit linked notes to these markets is expected to dry up in Germany.

(2)   What are the motives behind the move?
In its press note the finance ministry – which backs the BaFin move – justified the measures by the observation of growing volatility in government bond prices, rising bond yields and CDS spreads. It argued further that naked selling of CDS might have a self-sustaining effect, threatening to destabilise financial markets. In short: the measures are designed to anticipate and deal with future market stress rather than a responce to current one. – Any link between CDS selling and market volatility would be rejected by official figures from the DTCC, which imply declining CDS sales during the last three months, the period of peak market stress.

(3)   Why did the government refrain from consulting its partners in the euro area?
The German move obviously reflected the assessment that conflicting interests between the economies in the euro area would not allow for a coordinated regulatory response. In effect the German move has been viewed as challenging the hands-off policies practiced in other euro area economies like France and the Netherlands - the complaint of French finance minister Christine Lagarde bears testimony to this. In this respect the German move should be seen in the context of bargaining tactics to forge a European-wide position on restraining certain trades.

At the current juncture the action of the German finance ministry can be viewed as part of a strategy to negotiate more restrictive trading rules within the euro area and curb market volatility. 

Investor protection act – striking balance between restriction and transparency

Whereas last week’s move focuses on outright restrictions, the announced extensions and upgrading to an “act for strengthening investor protection and improvement for the functioning of capital markets” aims to strike a balance between outright prohibition and increased transparency.

To this effect the government intends to extend the short selling to all listed stocks and to currency derivatives beyond hedging purposes. This move intends to put a break on self-sustaining market movements, ie. speculation-induced volatility. But it seems that by curing the symptoms rather than the causes, ie changes in longer term market expectations, the government action might be counterproductive. It is also seen as a threat to market liquidity, in particular to instruments, which are not traded on stock exchanges.

But this view might be contentious, as a study on regulation of the derivatives market just published by a NY based banking institution argues. Should regulation (in general) help more standardisation in execution, in clearing, in reporting and regulatory oversight of OTC derivatives market participants, the resulting move towards standardisation might result in cost savings for banks and attract new business from non-banks.

Tight deadline for legislation reflects little consideration for international coordination

Whereas the case for tighter regulation of derivatives market seems agreed by both EU and international bodies such as the G20 financial market committee, tight deadlines for the legislative process in Germany are likely to be counterproductive to a coordinated approach.

Following the 25 May announcement of the government initiative, banking experts had been given a two day deadline to comment on the draft. By the end of June the amended draft is to be presented to both houses of parliament and before the mid-July summer recess the legislation process shall be concluded. With the opposition SPD having signalled its consent, legislation for the “act for strengthening investor protection and improvement for functioning of capital markets” appears to have a smooth run. The act would then take effect by the beginning of 2011. 

Against this background the German government risks missing a chance to contribute to a more coordinated approach on market regulation, reaping the benefits for both sides of the markets, as stated by the abovementioned banking analysis.

For further information please contact:

Dr Michael Clauss: Politics / Economy / Equities Sectoral Analysis

Tel: +49 89 64254046

Michael.clauss@eurozoneadvisors.com

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