Key Issues Controversial

New EU measures on short selling and CDS

Originally published in the February 2011 issue

The European Commission’s proposed regulation to create a harmonised framework for short selling and certain credit default swaps (CDS) across Europe has been passed to the European Parliament and the European Council for adoption. Once adopted, the regulation would apply from 1st July 2011. However, a number of key issues are controversial and still being fiercely debated.

The regulation aims to address perceived risks of short selling, namely transparency deficiencies, negative price spirals, and settlement failures. It requires firms to disclose short positions to regulators and the market and gives European Sales and Marketing Association (ESMA) power to restrict or ban short selling temporarily in “emergency situations”. A number of the Commission’s proposals go beyond recommendations made by CESR, including the flagging of short sale trades, the establishment of mandatory buy-in arrangements, and requirements to reserve (as opposed to simply locate) securities before selling short.

Industry representatives believe some of the Commission’s proposals are disproportionate and may have negative consequences for the financial markets and its users. However, some politicians believe the Commission’s proposals do not go far enough. A compromise text proposal drawn up by Pascal Canfin (a French Green Party member of the European Parliament who is acting as Parliamentary “rapporteur” on the proposed regulation), contains proposals for curbs on short selling which go some way beyond those of the Commission. As rapporteur, Pascal Canfin will play a key role in steering the regulation through Parliament. Meanwhile, the Council’s Belgian Presidency has also published a compromise text proposal and, according to a progress report produced by the Belgian Presidency, national delegations’ views on the proposals are still divided.

Key proposals and outstanding issues
The key proposals, together with main areas of controversy, are summarised below.

Scope (Article 1)
The Commission’s proposed regulation will apply to (i) all financial instruments admitted to trading on a trading venue in the EU, including when traded off market (OTC); (ii) derivatives related to such instruments and their issuers, including when traded OTC; and (iii) sovereign debt instruments of Member States and the EU and derivatives relating to such instruments.

According to the Belgian Presidency’s progress report, some national delegations strongly oppose the inclusion of sovereign debt instruments in the scope of the regulation. They consider that there is no evidence of the need to regulate the sovereign debt market and that these rules might be detrimental to the functioning and the liquidity of this market. Meanwhile, Pascal Canfin’s report supports the inclusion of sovereign debt instruments within the scope of the regulation. Indeed, it goes beyond the Commission’s proposals by proposing to allow only owners of sovereign debt to purchase sovereign debt CDS, arguing that all CDS purchases should be based on the insurable interest principle. The report also goes further than the Commission by proposing to bring corporate debt, CDS of corporate debt, leveraged long positions, and OTC transactions within the scope of the regulation.

In December 2010 a previously unpublished report prepared by Commission staff in May 2010 came to light after a Dutch newspaper obtained the document through a freedom of information request. This found “no conclusive evidence” that CDS trading led to “higher funding costs” for member states, contrary to fears expressed by the German, French, Greek and Luxembourg heads of state that financial speculation had pushed Greece towards default. The report concluded that it was high debt levels and “the deterioration of budget deficits” which had caused the market developments, and that “there is no evidence of any obvious mis-pricing in the sovereign bond and CDS markets”. The report undermines calls for legislation to curb trading in sovereign debt instruments.

Some, including Pacsal Canfin, argue that naked sovereign CDS positions are illegitimate because they are insuring something the investor does not own. The counter-argument is that the CDS market in sovereign debt plays an important function in allowing market participants to hedge country-specific risks. For example, investors with large holdings in a particular country may use them to hedge against systemic shocks which could reduce the value of their investments. Lending institutions may use sovereign CDS as protection from credit or counterparty risk arising from lending in a particular country. Investors purchasing sovereign debt at issue, not knowing in advance what allocation they will receive, may first enter into a naked sovereign CDS to ensure the eventual allocation is within their appetite. This makes it less risky, and therefore facilitates purchase of sovereign debt and could therefore be considered beneficial for funding of sovereign deficits.

Transparency (Articles 5 to 11)
The Commission’s proposed regulation proposes a two-tier disclosure model with private disclosure to competent authorities of short positions that exceed 0.2% of the issued share capital of any European company, and disclosure to the public of short positions that exceed 0.5%. It also proposes a requirement to notify the relevant regulator of net short positions relating to sovereign debt over a certain level (and at subsequent incremental levels), but these levels are to be specified by delegated legislation. It proposes that trading venues be obliged to introduce procedures to mark short orders and to publish daily summaries of short orders.

With regards to marking of short orders, the Belgian Presidency’s progress report states that a number of national delegations are against the proposal, arguing that it would not stand a cost-benefit analysis and might drive business out of trading venues. The Belgian Presidency has asked delegations to consider an alternative, notably the introduction of an additional field in the transaction reporting obligations of intermediaries. Pascal Canfin’s report proposes to extend the disclosure regime to corporate debt, corporate debt CDS, and leveraged long sales. It supports the marking of short orders and, indeed, proposes extending the marking regime beyond trading venues to OTC transactions. It therefore imposes associated obligations (when orders are executed OTC) on investment firms (as well as on trading venues, as proposed by the Commission).

With regards to disclosure, while many in the industry accept that private and public disclosure of short sales would meet the aim of increasing transparency, this is subject to any public disclosure being on an anonymous, aggregate basis. Concerns have been raised that naming of individual position holders can lead to market distortion, as some managers may limit their net short positions at whatever level is necessary to remain under any applicable threshold, regardless of their view on the stock in question. There is a danger of “herding” where other investors copy a short selling strategy without knowing its rationale, potentially exacerbating the negative impact on price and encouraging volatility. Public disclosure of their positions exposes named position holders to having their proprietary management strategies being “reverse engineered”, diluting the value of the approach to the investors in the funds managed by the managers in question. The concern has also been raised that the disclosure thresholds should not be set too low.

With regards to the marking regime, concerns have been raised that information obtained from marking would be incomplete and potentially misleading as it would not show individual market participants’ net positions and would not (under the Commission’s proposal) cover OTC sales. It would not be possible to rule out inaccurate reporting and it would be difficult for trading venues to verify or enforce.

Uncovered (naked) short selling and mandatory buy-in procedures (Articles 12 and 13)
The Commission’s proposed regulation prohibits short selling of shares or sovereign debt instruments unless at the time the short sale is entered into the instrument has been borrowed, an agreement has been entered into for it to be borrowed or other arrangements have been made which ensure that it can be borrowed. Trading venues must ensure that there are adequate arrangements for buy-in of the instruments where there is a failure to settle a transaction and for daily fines to be imposed for settlement failures.

According to the Belgian Presidency’s progress report, national delegations are divided on the need to impose any permanent restrictions on short selling, more specifically in relation to sovereign debt instruments. Some argue there is not enough evidence to do so, and that this will reduce liquidity on the markets. Delegations are also divided on the proposals to enhance settlement discipline. Some oppose because of the lack of evidence of a causal link between short selling and settlement failures. Some are in favour, but believe that the regulation is not the appropriate text to do so. Meanwhile, Pascal Canfin’s report goes beyond the Commission’s text by proposing to extend the obligatory buy-in procedures beyond trading venues to OTC transactions. It therefore imposes associated obligations not only on trading venues (as proposed by the Commission) but also, when orders are executed OTC, on investment firms.

Some in the industry have made the point that requiring short sellers to formally “reserve” as opposed to “locate” stocks is likely to cause a liquidity drain since such an obligation might lead to an escalation of precautionary activity by potential borrowers who are seeking to preserve their flexibility to engage in future short selling. This could reduce market liquidity, pushing up the cost of borrowing and leading to hoarding of securities. Current market practice in locating stocks for short selling (whereby a potential short seller checks informally that its broker or custodian or other third party would be willing and able to lend the relevant security), does not appear to have led to any significant problems with settlement failure as the Commission itself accepts that the level of settlement failure is low.

It is generally accepted that there are many reasons why a trade may fail to settle, with short selling being only one of these. Other causes include, for example, delayed deliveries on a back-to-back or contingent transaction; lack of stock; lack of cash; frozen accounts; or administrative errors.

Exemptions (Articles 14 and 15)
Exemptions from the rules are proposed for shares of a company where the principal market for the shares is outside the EU. There are also exemptions proposed for certain market making activities, primary dealing activities and stabilisation activities.

Emergency powers of competent authorities (Articles 16 to 22)
In the case of adverse developments that constitute a serious threat to financial stability or market confidence in a member state, the proposed regulation provides that competent authorities will have temporary powers to restrict or prohibit short selling activities or impose additional disclosure obligations. Such measures could apply for a period of no more than three months but could be renewed for further periods of up to three months at a time. Short selling may also be temporarily restricted in the case of a significant fall in price of a financial instrument (in the case of shares, being 10% or more) during a single trading day.

Coordination among competent authorities and role of ESMA (Articles 23, 24 and 30)
The regulation gives ESMA emergency powers to itself prohibit or restrict short selling activities or impose additional disclosure requirements in case of unjustified inaction of a competent authority.

The Belgian Presidency’s progress report states that a number of national delegations believe this goes too far, and/or don’t want ESMA to interfere in the sovereign debt market. The Belgian Presidency has proposed as a compromise that emergency measures by ESMA in relation to sovereign debt instruments require the consent from the competent authority of the relevant Member State.

The Commission’s proposed regulation does appear to give ESMA unprecedented powers to intervene in the workings of the markets and, in particular, to require disclosure of, essentially, any short position, to prevent a person entering into transactions involving financial instruments or to prohibit short selling altogether (albeit on a temporary basis). In retrospect, it is not clear that restrictions on short selling which were introduced (usually as an emergency measure) by a number of EU jurisdictions in 2008 and 2009 were beneficial.

Next steps and conclusion
The Belgian Presidency concluded in its progress report that further technical debate appears necessary before seeking guidance at political level as to the options to be followed. It has invited the Council to take note of the Presidency compromise proposal, and has invited its successor (from 1st January 2011), the Hungarian Presidency, to continue work on the basis of this compromise proposal in order to reach an agreement on a general approach in the near future.

With regards to the approach which will be taken, it remains to be seen whether sovereign debt instruments will remain in the scope of the regulation. Pascal Canfin’s proposals to allow only owners of sovereign debt to purchase sovereign debt CDS and to bring corporate debt, leveraged long positions, and OTC transactions within the scope of the regulation could potentially have significant implications for the industry. Any regulatory interventions must be careful to ascertain whether such proposals are supported by evidence, consultation and cost-benefit analysis. It is also hoped that competent authorities or ESMA would be very cautious about imposing bans on short selling in future.

It makes sense to establish a harmonised framework for short selling in place of the current fragmented approach. The proposed regulation is an opportunity to bring genuine benefit to market participants by replacing the current regulatory patchwork with a single harmonised regime, making compliance simpler and less costly.

It also makes sense for regulators to have sight of material short positions taken by investors, as market participants generally accept that if regulators have sight of material short selling positions it should help to allay any concerns that this activity is problematic.

A proportionate and sensible regulatory approach to ensure that uncovered short selling doesn’t lead to unacceptable incidents of unsettled trades may also be desirable. However, it may make more sense for measures relating to settlement failures to be considered as part of a separate legislative initiative not limited to short selling in the absence of justification for short sales to be subject to different buy-in rules from those imposed on any other purchase or long sale.

At times when equity and bond prices are falling commentators often criticize short selling, claiming that it leads to disorderly markets and exacerbates price falls. The Explanatory Memorandum which accompanies the Commission’s proposal specifically recognises that short selling is a legitimate technique which contributes to market efficiency by increasing liquidity, by enhancing price formation and by acting as an early indicator of underlying problems within an issuer.

The challenge regulators face is to develop rules thatprovide confidence that short selling will not damage the market, without reducing the beneficial role that short selling can play.

Lucy Frew is a senior financial services lawyer at Gide Loyrette Nouel specialising in UK and EU financial services regulation and investment management.