The draft law would prevent anyone from buying a credit default swap – a type of insurance policy against a defaulting issuer of the debt - without owning a stake in the corresponding debt.
"Naked" short selling, purchasing an insurance contract on a security without actually owning it, has been blamed for driving the kind of speculation which increases the likelihood of the issuer's default.
"Purchasing Italian CDS, for example, will now be possible only if the buyer already owns Italian government bonds or a stake in a sector highly dependent on the performance of these bonds, such as an Italian bank," says a European Parliament statement on the draft ban.
Many governments blame CDS for driving up the cost of a country's borrowing and therefore its sovereign bond yields. And the more a country, like Greece, looks like it will default, the more default swaps are bought, critics argue.
The yield on 10-year Greek bonds rose from 5% at the end of November 2009 to 6.5% by mid-February 2010, corresponding with a spike in the purchase of CDS.
But market and UK officials have criticised the legislation, arguing it will do more damage than good. The UK is home to the EU's biggest financial market.
UK officials in Brussels have questioned the legality of an EU authority's ability to ban short-selling. They are currently suing the ECB over possible curbs to clearing houses dealing in euro currency outside the eurozone.
Financial players, especially hedge funds, whose operations are heavily reliant on short-selling, argue that the practice and CDS are fundamental ways to keep markets liquid.
Their position was bolstered by a report the European Commission tried to brush under the carpet which showed little correlation between CDS and bond spreads.
"The empirical investigation that has been conducted by the task force on how the sovereign CDS and bond markets interact, provides no conclusive evidence that developments in the CDS market causes higher funding costs for Member States," the report leaked to the Dutch newspaper Het Financieele Dagblad said.
But the ban appears to have been predestined by political pressure.
In June, French President Nicolas Sarkozy and German Chancellor Angela Merkel called on the commission to impose a ban on speculation against the widening yields of sovereign debt.
This is in stark contrast to another regulation on credit rating agencies that was waved through yesterday. Parliamentarians and large EU governments have cast it as a climbdown because it stops short of suspending the ratings of countries with rising sovereign debt.
France, Italy, Greece, Spain and Belgium all have short-selling curbs in place. France extended the duration of its ban last week.
The EU ban is due to come into force a year from now in all 27 countries.
