Q+A: How will EU clamp down on financial speculators?

BRUSSELS (Reuters) - The European Union is set to propose a new code to control short selling and the trading of derivatives.

Here is a summary of the proposals to be unveiled on Wednesday:

WHY DOES THE EU WANT TO REGULATE SPECULATORS?

Once labeled by billionaire Warren Buffett as "financial weapons of mass destruction," derivatives have been under scrutiny since they amplified the collapse of Lehman Brothers, sparking panic in global financial markets.

As Buffett predicted years before the crisis, the "time bombs" of financial engineering multiplied and the market today is worth roughly $600 trillion.

Most derivatives, whose value is linked to the price of an underlying financial instrument or commodity, are traded over-the-counter or off-exchange, far from the watch of regulators.

Politicians suspect the market, which industry also taps to guard against swings in the price of raw materials or currencies, is largely in the hands of speculators such as hedge funds.

The European Commission -- the Brussels-based civil service for the bloc's 27 countries -- wants better identification of trades in this opaque market, where many multi-million-euro deals are recorded only by a fax between seller and buyer.

The EU will also set up a new pan-European watchdog to prevent countries imposing maverick short-selling bans as Germany, Britain and other countries did following the collapse of Lehman.

This new financial sheriff will also be tasked with monitoring speculators, such as those who were blamed for exacerbating Greece's borrowing problems by betting up the price of insuring its debt.

WHAT WILL THE EU CHANGE?

Brussels wants more standardization of derivatives and will ask derivative traders to use clearing houses which would provide a safety net in the event of a collapse like Lehman, by stepping in should either buyer or seller to a trade go bust.

A new pan-European watchdog will police this changeover, which is set to happen by the end of 2012.

Companies such as airlines and carmakers, who use derivatives to insure against risks but account for only a small part of the market, would escape many of the new rules.

HOW DOES IT PLAN TO TACKLE SHORT-SELLING?

The Commission wants to give powers to a new European Securities and Markets Authority to ban some trading if markets start to wobble.

This agency will be able to temporarily stop short selling of shares or the naked selling of credit default swaps and sovereign debt. Short selling is "naked" when sellers have not arranged to borrow the assets they promised to sell.

The watchdog will be allowed to take action against trading in derivatives of sovereign bonds and credit default swaps, a form of tradeable insurance in government bonds.

The new agency, due to be in place from January, will have the authority to overrule European countries who go it alone with curbs on trading. It will also be allowed to impose a ban on any bank if it is suspected of selling short and triggering a big daily price fall.

This circuit breaker could be used if prices drop beyond 10 percent.

In a bid to open up this opaque market, traders will have to reveal significant net short positions in shares, government debt and sovereign credit default swaps to regulators and even markets.

Traders may also have to flag to the stock exchange if their share-sale orders are part of a short sale.

Short sellers in shares and government debt will have to organize to borrow the assets so they can settle the trade on time or otherwise face a daily penalty.

WHO ARE THE WINNERS AND LOSERS FROM THE NEW RULES?

The derivatives market is dominated by roughly half a dozen large banks such as Deutsche Bank, Barclays, Goldman Sachs, JP Morgan, Bank of America and Citigroup.

They design the derivatives for customers and trade them among themselves. The new law is likely to challenge their influence by forcing more transparency.

Hedge funds and other investors also stand to lose out if the new markets watchdog demand they outline key trading positions, which could make them vulnerable to rivals.

(Compiling by John O'Donnell; Editing by David Holmes)