EU Seeks To Regulate The Derivatives Market

By: Dr. Mike Campbell

The European Union is drawing up legislation which it hopes will bring transparency and order to the markets with respect to short-selling and naked short-selling. The practice of derivatives trading is poorly understood outside of stock markets, but essentially a derivative is tool which allows a trader to “bet” on the underlying value of an asset without actually owning it (the value is “derived from” the asset – hence the term).

In short-selling, the trader may borrow assets at a certain price and return them later on when the price of those assets has fallen, making a tidy profit (the owner of the asset will receive a payment for the provision of the facility). The EU, naturally enough, is uncomfortable about the practice which allows traders to make profits in a falling market, and wants to assess the extent of it. Many people have expressed the view that short-selling contributes to economic instability and may have played a role in exacerbating the recent EU sovereign debt crisis.

The nature of derivatives trading (in that assets are not actually exchanged) means that it is not under stock market regulation, being a so-called over-the-counter trade. The value of the derivatives market has been estimated to be worth $615 trillion; not an insubstantial sum in anybody’s book. The EU proposals would call for a watchdog to be set up to oversee this market. Traders may be forced to declare their “short positions” in a central database and new rules might require that they had the assets on hand to cover the losses from these positions if the market moved in the other way. The new legislation would come into force as early as 2012 if it gets the required governmental backing.