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Naked Sovereign CDS Ban to Apply to Market-Makers, ESMA Says

The European Union’s top markets regulator granted market-makers an exemption from some tougher rules on short-selling, while stopping short of allowing them to trade naked sovereign credit-default swaps.

The European Securities and Markets Authority, set up in 2011 to harmonize rules across the bloc, said products that aren’t traded on a regulated market, including sovereign CDS, wouldn’t qualify for the exemption.

“ESMA has taken considerable time to closely consider the regulation and explore through a legal analysis whether there were ways to accommodate non-admitted/non-traded instruments,” the Paris-based agency said in a report on its website today. “Results of the analysis led to a negative conclusion.”

German Finance Minister Wolfgang Schaeuble and lawmakers in the European Parliament have called for a ban on naked CDS trades on government debt over concerns the practice fueled the euro-area debt crisis. Germany already has restrictions on using swaps to bet on sovereign defaults. The EU agreed on short-selling restrictions, including on sovereign CDS, last year. ESMA’s guidelines clarified whether market-makers were subject to the curbs.

Credit-default swaps are derivatives that pay the buyer face value if a borrower -- a country or a company -- defaults. In exchange, the swap seller gets the underlying securities or the cash equivalent. Traders in naked credit-default swaps buy and sell insurance on bonds they don’t own.

A market maker maintains a liquid market for a particular security by buying and selling as circumstances require.

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