The European Central Bank supports temporary bans on naked short selling of European credit default swaps and shares in extreme market conditions, but has warned against permanent action to stop shorting.

Limitations or bans should be limited in time and in scope in case of exceptional circumstances, the ECB said in a submission on proposed new European Union rules.

The European Commission is preparing legislation to allow bans on naked short-selling of shares and some trading of credit default swaps (CDS) although it has stopped short of proposing a permanent ban.

Naked CDS trades, in which investors can insure sovereign debt against default without having to own the underlying bond, have been blamed by Greece and others for amplifying government debt woes. Germany announced a unilateral ban on naked CDS contracts in May.

The ECB said it had similar reservations about completely banning naked CDS trades as it did about short-selling in general, which also had benefits for market participants, but called for more transparency in bond market trades.

While a complete ban on naked short selling might potentially reduce the possible risks for the markets, the potential adverse effects of such a very restrictive measure should be carefully considered, the ECB said in the submission, published overnight on its Website.

Regulators should be attributed adequate powers to impose a temporary ban in order to react to extreme circumstances whereby the broad market positioning negatively impacts on the issuer.

If significant market speculation led by short sellers can be evidenced in future situations, a temporary short selling ban on both sovereign cash bonds and CDS markets could in such cases be agreed upon.

Short selling is the sale of a security the seller does not own and is typically a bet the price will fall by the time the seller must buy the stock to settle his trade. The difference in price is pocketed as a profit.

Naked short-selling is where the seller does not own or has not borrowed the security at the time of the short sale.

The ECB backed proposals by the Committee of European Securities Regulators to improve transparency and said regulators should have more powers of enforcement to ensure that trades are settled.

Higher penalties could be envisaged if trades failed, it said. For a factbox on the EU plans, please see [ID:nLDE65D1CJ]

For a copy of the ECB submission, please see http://www.ecb.int/pub/pdf/other/eurosystems_reply_to_a_commission_public_consultation_on_short_sellingen.pdf

(Reporting by Krista Hughes; editing by Patrick Graham)

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