• Welcome
• Background
• Timeline and next steps
• Expected industry implications – selection of some key aspects
• Impact

Welcome

Natalie Westerbarkey
Director, EMEA Client and Sales Management
Global Transaction Services, Citi

This Regulatory Spotlight will address the latest update on European Short-Selling regulations and certain aspects of credit default swaps (CDSs).

Background

In the light of the financial crisis over the last years and the Eurozone debt crisis in 2010, where various EU 27 member states such as Germany and France took individual and un-coordinated emergency measures at national level such as the temporary restriction or ban on the short-selling of specific instruments, the European Commission decided that a pan-European legislative framework was required to address these aspects. It adopted a regulatory proposal on 15 September 2010 that also included certain provisions relating to (sovereign) CDSs and that aimed to ensure coordination at European level, equip member states with necessary intervention powers, increase transparency and reduce risk.

The proposals, even following a compromise text prepared this month, seek to impose wide-ranging duties on market participants (notwithstanding market maker exemptions). Items such as the public disclosure reporting requirements on individual short-selling positions and the inclusion of sovereign CDSs into the legislative framework have provoked much industry comment, so the political debate will continue through the first half of 2011. The final measures at national level are expected to come into force in July 2012.

ESMA – the new European Securities Market Authority – that came into existence in January 2011 and that replaces the former CESR authority (Committee of European Securities Regulators) – is equipped with enhanced supervisory powers to ensure greater consistency across all EU 27 member states. In the context of short selling ESMA is empowered to provide opinions to local authorities in cases of emergency interventions and can even adopt temporary measures itself that are directly binding on the markets.

Timeline and next steps

September 2010

The European Commission adopts proposals for the regulation of short selling and certain aspects of CDSs.

As this legislation is designed as a regulation, it is directly applicable to industry participants once it comes into force and does not need to be transposed into national member state law like a directive does.

February 2011

The Hungarian EU Presidency publishes a draft compromise text that will form the basis of the political discussions in the coming months. The European Parliament is expected to vote on possible amendments to the draft regulations.

March 2011

EU finance ministers are scheduled to meet on 15 March 2011 when this regulatory draft is expected to be on the formal agenda.

Q2/Q3 2011

Agreement on the final version of the text is expected by mid 2011 at the latest with adoption in late 2011.

1 July 2012

Envisaged entry into force – law becomes directly applicable to the industry.

Expected industry implications – some key aspects

Disclosure of net short-sale positions

Policy makers acknowledge that short-selling techniques support market liquidity and efficient pricing. But in distressed markets, they also consider that the techniques can amplify fails and lead to disorderly markets and systemic risk. Enhanced transparency of net short positions in shares where the principal trading venue is inside the EU – to regulators at 0.2% and 0.1% increments thereafter and publicly at 0.5% and each 0.1% above that – via notification to competent authorities would enable regulators to monitor for systemic risk and market abuse. Thresholds for reporting net short positions in sovereign debt and CDSs have not yet been indicated.

However, it remains a matter of some debate whether there is conclusive evidence to corroborate that short selling per se (not constituting a market abuse) – for shares and in particular for sovereign debt or sovereign CDSs – has damaging systemic effects and should be regulated at all by short selling provisions.

Uncovered short selling

Restricting so-called naked or uncovered short selling to limit potential risk of settlement failure is also envisaged. The latest proposal suggests that a seller must have borrowed the shares or sovereign debt it plans to short-sell, made arrangements with a third party either to locate the instruments or have another reasonable expectation that settlement can be made on contractual settlement date.

It is noteworthy that the previous proposal to both "locate and reserve" a security prior to its short-sale has been dropped from the February 2011 compromise text. This reservation requirement was widely viewed as an implicit ban on uncovered short selling and its proposed deletion is welcomed given the costs of setting aside securities for settlement, the increase in transaction costs and the likelihood of reduced market liquidity.

Impact

Disclosure to the market

Asset managers may benefit from a harmonised framework and consistent common regime for regulatory intervention measures across Europe and increased reporting requirements to the regulators may support greater transparency. However, disclosures to the market regarding short-selling positions of individual stocks or short-selling bans could have an adverse effect on market efficiency.

Asset management companies are likely to be much more limited in the way they manage investment risk as the shorting of companies, sovereign debt and sovereign CDSs would become transparent to regulators and the market. It would potentially allow other market participants to take insights into each other’s trading strategies and views that are taken on the underlying entity, i.e. companies or specific countries in case of shorting sovereign debt or CDSs.

The provisions will furthermore have an impact on liquidity, the equity bid-ask spread will likely widen and short squeezes would probably intensify. This outlook is based on empirical analysis some firms have undertaken on the recent UK’s FSA public short-selling disclosure requirements, which showed a double-digit drop in trading volumes with a bid-ask spread widening almost 50%.

The public disclosure rules are expected to increase costs of hedging strategies or make them less effective if public data on short positions is used to distort price drivers in the market. Worst case, this might result in a decreased demand for stock-lending programmes.

These outlined adverse implications could be limited by either mandating the disclosure requirements to regulators only and not to the market or at least through limiting the disclosure reporting to the market of positions in aggregate and anonymised form (instead of individual stocks sold short) and/or increasing the disclosure threshold from 0.5% to for example 3.0%. Otherwise, asset managers may re-consider their equity capital allocation away from Europe and increase trading for example in Hong Kong or the US where short selling disclosure guidelines are in place that do not require the disclosure of individual shorting positions to the market.

Sales of long lent positions

A repo is proposed to be excluded explicitly from the definition of a short sale; however, the situation where an investor sells its lent position in a stock and then recalls for contractual settlement date is not. Discussions continue to clarify this position because, even though this would be a covered short sale (enforceable legal claim to meet the settlement date delivery obligation), the disclosure requirements would still need to be met.

Current regulatory position in example markets (short selling of shares)

To discuss the matter please contact your client executive or email or natalie.westerbarkey@citi.com