Short selling is the sale of a security the seller does not own at the time of entering into the agreement with the intention of buying it back at a later point in time in order to deliver it.

It can be divided into 2 types

  • covered short selling is where the seller has made arrangements to borrow the securities before the sale
  • naked short selling is where the seller has not borrowed the securities when the short sale occurs

A credit default swap (CDS) is a derivative contract which acts as a form of insurance against the risk of credit default of a corporate or government bond. In return for a series of payments, the credit risk is transferred from the buyer to the seller. If the issuer defaults, the CDS seller pays the buyer the face value of the instrument. An uncovered or naked CDS is when the buyer of a CDS is not exposed to the credit risk of the underlying reference entity.

Risks of short selling and credit default swaps

Short selling and CDS may generate economic benefits such as increasing market liquidity. However, they also carry certain risks, such as

  • negative price spirals
  • settlement failures
  • transparency deficiencies resulting in risks to financial stability, market integrity and information asymmetries between market participants

EU rules on short selling

Since the onset of the financial crisis in 2008, many EU countries have taken action to suspend or ban short selling. However, because these were uncoordinated, it was possible to circumvent restrictions in one jurisdiction by carrying out transactions in another. They also created additional costs and difficulties for investors operating in several markets.

Therefore, in 2012 the EU adopted a regulation which

  • increases transparency by requiring the flagging of short sales, so that regulators know which transactions are short 
  • gives national regulators powers – in exceptional circumstances, and subject to coordination by European Securities and Markets Authority (ESMA) – to temporarily restrict or ban short selling of any financial instrument
  • requires central counterparties providing clearing services to ensure that there are adequate arrangements in place for buy-in of shares as well as fines for settlement failure