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Could restricting short sales hurt repo market?

European Union discussions to limit short selling, especially naked short selling, are meeting with objections from some of its member nations who fear the move would make it harder for them to raise money by selling debt on the repurchase market, Bloomberg News reported March 22.

The dispute shows the critical role that repurchase agreements play in the debt markets of Europe, as political leaders fight to keep repos functioning smoothly.

 Short selling is a key component of the repurchase market, because it is an important way that traders acquire securities to use as collateral.   In a short sale, a trader may repo a security from a central bank so he can sell it to someone else at a better price. Then he hopes the value of the security will fall, so he can buy it at a lower price to return to the central bank.

In naked short selling, the seller of the security never owns it, never borrows it. For example, a dealer might repo to a central bank a security that the dealer doesn’t own. The dealer hopes to use the repo cash profitably before it has to repurchase the security from the central bank.

Traders, including central bankers, often value the liquidity that short sales bring to the fixed income market.

From the Bloomberg story:

Governments in the 27-nation EU and lawmakers in the European Parliament are discussing whether to restrict so-called naked short selling after German Chancellor Angela Merkel and French Finance Minister Christine Lagarde blamed the trade for encouraging speculation.

Sweden says without the access to naked shorts — which investors rely on to enter repurchase agreements with the country’s central bank — bond-market liquidity will evaporate. The naked short contracts allow traders to generate more liquidity via the repo transaction than they’d be able to without access to the derivative, said Mats Hyden, chief strategist at Nordea Bank AB (NDA) in Stockholm. …

Sweden, which is backed by Luxembourg and Italy in opposing a ban on naked shorts, risks a surge in borrowing costs should a ban be approved, said Thomas Olofsson, head of debt management at Sweden’s national debt office, in an interview. …

Governments will try to complete work on short selling rules by May, said Gyorgy Matolcsy, the finance minister of Hungary, which holds the EU’s rotating presidency.

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