Germany’s financial regulator BaFin yesterday imposed new restrictions on short selling by market participants. The restrictions prevent uncovered short sales of ten financial sector equities and of Eurozone government bonds, subject to certain exemptions made available to market makers (“uncovered” means a short sale of securities where the seller has not previously arranged to borrow them, such as under a securities lending transaction).

In addition, BaFin has announced that it will prohibit new credit derivatives contracts based upon Eurozone government debt, excepting those that are used to hedge existing long positions. In effect, the use of credit default swaps (CDS) to take an outright short view on the solvency of a Euro member state is no longer permitted in Germany.

The bans are in effect from today until 31 March 2011. An English language translation of the BaFin decrees are available at the following links: credit derivatives, financial stocks, and Eurozone government debt.

Securities lending experts and ETF market participants had mixed opinions as to the likely impact of the German regulator’s move.

According to one securities finance expert, “The fact that the German regulator’s ban is confined to so-called “naked” short selling means that the repo and the securities lending markets will be untouched. Most of those markets’ activity is in London, anyway. So I’m a little confused as to the intended effect of the new restrictions. Including the CDS market in the ban has already led to a big jump in bid-offer spreads and an overall decrease in liquidity, which I’m not sure was what the regulator intended.”

“Naked short selling is already banned in most markets, anyway,” added the commentator. “If the ban is specified as on naked shorting only, but intended to give the impression that covered shorting should also be frowned upon, then there will be much bigger problems in the repo market. There could also be an unwelcome knock-on effect of the move if it affects liquidity in the government bond markets. Bond markets rely on the ability of participants to position themselves both ways round, that is both long and short.”

A London-based trader in the European sovereign CDS market confirmed that BaFin’s intervention had hit liquidity on Wednesday morning, commenting that “liquidity has just disappeared, basically.” Although other European countries have so far not followed Germany’s initiative, and some, according to the Financial Times, have even spoken out against it, “no one really knows what further regulations might follow, and so people are unwilling to trade,” the trader remarked.

According to the FT Alphaville website, bid-offer spreads on European government sovereign CDS widened to as much as 200 basis points in early trading on Wednesday.

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