In June and July the complexities of the European regulatory machinery produced the final pieces of the Short Selling Regulation (SSR). The regulation itself came into force on March 25th 2012 but required four Level 2 measures, comprising regulatory and implementing technical standards and delegated acts to complete the detailed requirements. Unlike directives, regulations have a direct effect on member states without the need for implementing measures. Therefore, despite the late release of the detailed provisions the effective date for the new requirements remains as 1 November 2012 and hence the time for firms to respond is short.
Whilst many participants have questioned the need for this latest layer of market oversight and restriction, the SSR does at least offer a consistent framework that concentrates on common rules for measuring and reporting. This contrasts sharply with the unilateral, politically motivated and largely ineffective measures taken by individual EU states against the perceived threat to their markets by short sellers. In the last weeks we have seen further restrictions and banning of short selling in Spain and Italy by politicians playing to a local audience. The SSR recognises the role of short selling in market operation and price discovery and therefore concentrates largely on reporting and transparency. Whilst the regulation provides the option for local short selling measures to continue in parallel until mid-next year the FSA has already made clear it intends to remove its existing disclosure regime to coincide with the start date of the SSR.
The SSR retains the ability for more direct action at state level and by ESMA on a European-wide basis in exceptional situations to reduce risks to financial stability and market confidence. However, on a day to day basis the onus on firms is to ensure that they are able to accurately measure short positions, establish appropriate cover and locate arrangements, notify the competent authority or make public disclosure when positions exceed or fall below defined levels and lastly ensure that they comply with complex hedging criteria for the holding of sovereign credit default swaps.
The SSR applies to short positions in the issued share capital of an entity 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. However, an important exemption is provided where the principal trading venue of the share is outside the EEA.
Principal trading market is determined by turnover. The regulations set out a process for identifying and publishing details of any exempt securities for which the provisions relating to notification, disclosure, restrictions on uncovered short sales and mandatory buy-in will not apply. ESMA will publish the list of exempted shares. Starting in 2014, the list will be updated on 1 April every second year.
The SSR provides an exemption for market-making activities for shares and those acting as authorised primary dealers for sovereign debt. Firms looking to take advantage of this exemption must meet stated conditions and notify the relevant competent authority not less than 30 days before using the exemption. Notifications can be made from the start of September.
For all other firms, the SSR prohibits naked short positions in shares and sovereign debt by requiring short positions to be either offset by long positions or for the manager to have put into place arrangements to effectively cover the short by means of one of the following actions:
• Share borrowing
• An agreement to borrow
• Confirmation with a third party that the security has been located and measures taken for the short seller to have a reasonable expectation that settlement can be made when due.
Firms will need to examine their arrangements with counterparties to ensure that documentation requirements are in place to meet the locate requirements. The arrangements must cover at a minimum the number of shares or amount of sovereign debt sold short. The agreement must be legally binding, entered into before or at the same time as the short sale and specify a delivery or expiration date that ensures the short sale can be settled when due.
A potentially significant challenge for managers is to ensure that on an ongoing basis their back offices are able to measure all individual net relevant short positions against issued share capital and comply with detailed requirements to report. The calculation of net short positions should take into account transactions in all financial instruments, whether on or outside a trading venue, that confer a financial advantage in the event of a change in price or value of the share.
Firms will need to be aware of situations where issuers have more than one share class in which case the total number of shares issued in each class should be added up to determine the percentage holding.
The SSR establishes a two-tier reporting system that comprises either reporting to the competent authority responsible for the principal trading venue, or publically. These provisions apply to all short sellers, whether located in the EEA or in a third country.
Notifications arise under the regulation whenever a net short position at the end of any trading day reaches 0.2% of the issued share capital of the company and then subsequently for each movement of 0.1% above that. The requirement to make public disclosure arises when net short positions reach 0.5% and then for each 0.1% above that. When holdings move below these thresholds notification and disclosure must also be effected.
The regulation also requires the notification to the relevant competent authority of significant positions in sovereign debt issuers including EU member states and supra-national issuers such as the European Investment Bank. There are two notification thresholds, depending on the issued size of the debt:
• 0.1% of issued sovereign debt when the total issued outstanding sovereign debt is less than €500 billion, with additional reporting for each 0.05% above the initial threshold.
• 0.5% of issued sovereign debt when the total issued outstanding sovereign debt exceeds €500 billion with additional reporting for each subsequent 0.25% position.
ESMA will update quarterly and publish on its website the notification thresholds for each sovereign issuer.
Back-office systems will need to be updated to meet the new requirements. Net short positions must be calculated as at midnight of the trading day concerned. Firms need to include all transactions executed in the position calculation (even where outside of normal hours). Where holdings require notification or disclosure these must be made no later than 3:30pm local time of the following trading day. The regulations set out the information and format to be provided in both the notifications to the regulators and public disclosure. The FSA’s recent Market Watch noted that in the UK the FSA intends to make use of its own web site to publish public disclosures. The FSA is developing a web-based solution for firms to submit to it disclosures and notifications in the format required under the regulation.
Additional complexities will arise for some firms by requirements to aggregate positions across funds managed by a single entity and across different entities within the same group. A management entity is required to aggregate the net short positions of the funds and portfolios under its management for which the same investment strategy is pursued in relation to a particular issuer. A firm managing funds for its own account alongside client accounts will need to separate out own account activities and perform two separate calculations and report as necessary. On a group level positions also need to be aggregated and netted across all own account positions to deter any attempts to avoid disclosure.
In addition to the requirements surrounding short selling the other main focus of SSR is to prohibit the holding of uncovered sovereign credit default swaps. Market practice of using sovereign CDS to provide a “proxy hedge” to a variety of other holdings, including cross-border positions, makes this area one of significant importance to many managers and was the subject of much discussion during the consultation phase of the SSR. To be considered as legitimate cover the hedged assets or liabilities must be proportionate in size to the CDS position and importantly bear sufficient correlation to the related sovereign issuer.
Correlation must be shown through either a qualitative or a quantitative test unless the holding is “per se” linked to the CDS. Under the quantitative test correlation is demonstrated when a correlation coefficient of at least 70% is shown based on specified data and methods. Under the qualitative test the holder must be able to demonstrate a meaningful correlation between the hedged exposure and the sovereign CDS and not just provide evidence of a temporary linkage. Certain hedged exposures may be deemed to meet the correlation test per se – for example, hedging regional government exposures using the sovereign CDS of the relevant state will be automatically deemed to meet the correlation test, without the need to perform either the qualitative or quantitative tests. In all cases the holder will need to demonstrate to regulators how the correlation test was met as and when required.
Whilst cross-border hedging is generally not permitted by the regulation certain limited exceptions allow for the hedging of multinational exposures.
All uncovered positions in a sovereign CDS entered into before 25 March 2012 may be held until maturity. However, any new positions entered into from that date will need to either be in compliance with the new regulation by 1 November 2012 or disposed of.
The main impact of the SSR is to establish common requirements for measuring and reporting short positions and setting out legitimate circumstances under which sovereign CDS may be held. However, it should be noted that considerable technical content is also provided to define situations where short selling may be additionally restricted or the regime suspended.
The intention is to provide flexibility to deal with exceptional market volatility or changes to liquidity. Unlike the current situation of unilateral individual state action, the SSR establishes set criteria for different instruments (in terms of type, size and liquidity) for when national regulators may impose additional transparency or restrictions on short selling or CDS transactions to prevent a disorderly market.
ESMA is given a central role in coordinating such actions and ensuring that national regulators only act where necessary. ESMA can also act itself when an exceptional development has a cross-border dimension.
The SSR is a significant and complex set of requirements that will replace all individual stand-alone short selling rules across the European Union. The demands on certain firms will be significant both in terms of how instruments, particularly sovereign CDS, may be used within portfolios and also in terms of the burden placed on operations, legal and compliance to understand and comply with reporting, monitoring and documentation requirements.
Tim Jukes joined IMS in 2011 and has over 20 years’ financial services experience. He provides advice to a broad spectrum of clients with an emphasis on collective investment vehicles.