Recent Developments
In response to the spreading European sovereign debt crisis and its effect on Eurozone sovereigns, financial institutions and the broader market, the European Parliament (EP) has just approved a wide-reaching Regulation1 that will substantially limit the ability of market participants to engage in short selling and credit default swap (CDS) trading in European listed shares and sovereign debt upon its entry into effect throughout the European Economic Area (EEA) on November 1, 2012. Certain Eurozone countries, not wanting to wait another year, have already implemented their own short selling restrictions, which generally are in line with but in certain areas go further than the Regulation.
Implications for Financial Industry Professionals
- Reinforcement of control over the European equity and sovereign debt markets.
- New reporting obligations for net short positions in EU listed equity securities and sovereign debt.
- Near-total ban on CDS on sovereign debt, absent a correlated long position.
- Full extra-territorial effect, covering trading both inside and outside the EEA.
- "Short selling restrictions already in place in Belgium, France, Greece, Italy and Spain.
What the Regulation Says
The key operative sections of the Regulation cover listed shares as well as sovereign debt and CDS on sovereign debt, both for reporting and substantive trading restrictions.
Reporting Requirements
The Regulation establishes a two-tiered disclosure system for net short positions in the issued share capital of a company that has its shares admitted to trading on a regulated market of the EEA or an EEA multilateral trading facility and for whom the principal trading market is in the EEA.
Short sellers must first notify to the competent authority of the most relevant market in terms of liquidity for a security whenever their net short position at the end of a trading day reaches 0.2% of the issued share capital of the company, and at each movement of 0.1% above that. The short seller must also disclose to the public net short positions of 0.5% and each 0.1% above that. The notifications must identify the short seller, and downward threshold crossings also must be notified.
Short sellers must also notify significant positions in sovereign debt and CDS relating to sovereign debt to the regulators, to assist them in monitoring whether such positions are creating disorderly markets or systemic risks or are being used for abusive purposes. However, short sellers must disclose the information only to the regulators rather than to the market, as it was feared that public disclosure could have negative consequences for sovereign bond market liquidity.
The EU Commission will determine what is a significant net short position in relation to each Member State and the EU. The European Securities and Markets Authority (ESMA) will publish on its website the notification thresholds for each Member State.
Borrowing and Delivery Requirements
In addition to the above reporting requirements, the Regulation bans uncovered short sales. A short seller may only may only enter into a short sale of a listed share where one of the following conditions is fulfilled:
- the short seller has borrowed the security or has made alternative provisions resulting in a similar legal effect;
- the short seller has entered into an agreement to borrow the security or has another absolutely enforceable claim under contract or property law to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due;
- the short seller has an arrangement with a third party under which that third party has confirmed that the security has been located and has taken measures vis-à-vis third parties necessary for the short seller to have reasonable expectation that settlement can be effected when it is due.
This last criterion is known as a "locate rule" and is similar to the borrowing and delivery requirements imposed by the U.S. Securities and Exchange Commission in Rule 203 of Regulation SHO. The same rules apply for sovereign debt, except the word "and" in the last criterion is replaced by the word "or".
Effective Ban on Sovereign Debt CDS
The most controversial part of the Regulation – and the main reason why it took six months of political wrangling among the EP, the European Commission and the Council (representing the Member States) before they finally reached a compromise position in mid-October 2011 – is the near-total ban on sovereign debt CDS.
The Regulation in essence prohibits entering into a sovereign debt CDS position unless there is an "insurable interest" in the underlying sovereign debt. In other words, a market participant may no longer use a CDS in order to speculate on the price of sovereign debt, but only to hedge a long position in the sovereign debt or other securities that are correlated to the value of that sovereign debt, such as the securities of a bank in the same country as the sovereign issuer. The basket of securities that can be hedged by a CDS includes financial contracts and a portfolio of assets or financial obligations the value of which is correlated to the value of the sovereign debt, such as index positions.
As a concession to Member States who were concerned that the ban on CDS would negatively affect their sovereign debt market, the national competent authority may lift the ban on unhedged CDS for a maximum of 12 months in cases where its sovereign debt market is no longer functioning properly, based on indicators set out in the Regulation, and then possibly renew it for further sixmonth periods if the grounds for the suspension continue to be applicable.
However, the EP insisted that even this power be constrained. Within 24 hours, ESMA would publish an opinion on its website as to the utility of suspending the ban or renewing the suspension. A negative opinion from ESMA would likely have political weight that could lead to the competent authority revising its decision, although ESMA would not have veto power over the decision.
Extensions and Exemptions
The Regulation contains various provisions designed to ensure that market participants do not use derivative positions to circumvent its rules. The calculation of short or long positions will take into account any form of economic interest obtained directly or indirectly through the use of derivatives such as options, futures, contracts for differences and spread bets relating to shares or sovereign debt, and indices, baskets and exchange traded funds.
On the other hand, the Regulation exempts market making and primary market activities, on the ground that these activities play a crucial role in providing liquidity to markets within the EU and market makers need to take short positions to perform that role.
Reinforced Regulatory Powers
The Regulation grants substantial additional powers to ESMA and the national competent authorities. In exceptional situations, the national authorities will have the power to impose temporary measures, such as to require further transparency or to restrict short selling and CDS transactions. The powers of intervention are temporary (for up to three months). They can be extended for further periods not exceeding three months at a time, but the national authority must fully justify the extension.
In the case of a significant fall in the price of a financial instrument in a single day, competent authorities may impose a restriction on its short selling until the end of the next trading day, which can be extended for up to two trading days if there is a further significant fall in value of the financial instrument.
ESMA may itself take action to ban share short selling where both short selling and other related activities threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the EU, and there are cross border implications and sufficient measures have not been taken by competent authorities to address the threat. However, the UK Government has announced that it may challenge this provision as exceeding the authority that can be granted to ESMA under EU case law.
Next Steps for the Regulation
The European Council must now adopt the same text as the EP, which should occur in December 2011. Publication of the Regulation in the Official Journal of the European Union is expected in early 2012.
Following a consultation procedure in the first quarter of 2012, the Commission and ESMA will prepare the required implementing technical measures, which will also go into effect on 1st November 2012. The Regulation and implementing measures will not be retroactive; the prohibitions are on entering into new unhedged CDS positions, and those existing on November 1, 2012, can be held until their maturity.
Actions to Consider
- Monitor closely the technical measures that ESMA and the Commission will adopt, and consider participating in any consultation procedures they may hold on the draft measures.
- Review and comply with the short selling restrictions already in place in Belgium, France, Greece, Italy and Spain.
- Put into place prime brokerage or master security lending agreements with global custodians that will satisfy the standards to be adopted by ESMA on what measures are necessary for a short seller to have a reasonable expectation that settlement can be effected when it is due.
- Put into place the back office systems necessary to calculate net short positions in the covered securities at midnight of the trading day and their notification when required to the regulators no later than 3:30 pm of the following trading day (based in each case on the local time of the regulator receiving the notifications).
- Be prepared for reinforced supervision of the European markets by the regulators, who will not hesitate to take enforcement actions against perceived violations of the Regulation and their national short selling rules.
Conclusion
Notwithstanding the lack of clear empirical evidence that short selling restrictions actually reduce volatility and increase market stability, the European Parliament, Commission and Council want to be seen as taking strong action to crack down on short selling and sovereign debt speculation. It is to be hoped that the technical measures from ESMA and the Commission that will implement the Regulation will eliminate perceived abuses while still allowing market participants to carry out their core functions of setting prices and creating liquidity.
Footnote
1 Regulation of the European Parliament and of the Council on Short Selling and certain aspects of Credit Default Swaps. The full text that the EP approved on November 15, 2011, is available on the its website at http://www.europarl.europa.eu/sides/getDoc.do?type=TA&language=EN&reference=P7-TA-2011- 0486.
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