The European Commission ("the Commission") has issued a draft regulation1 on short selling and certain aspects of credit default swaps. The aim is to replace the different national rules (hastily implemented in September 2008) with a more unified regime across the 27 Member States of the European Union, and to establish a framework for coordinated regulatory intervention. The regulation will make the EU's regulatory framework more convergent with that of the United States and Hong Kong. This briefing reviews the main aspects of the Commission's draft regulation and the next steps in the legislative process.
The proposal will require disclosure of short positions in equities whose principal market is in the EU. The rules apply whether the short position is accumulated on a trading venue or over-the-counter, and to sellers situated outside the EU:
- Disclosure of net equity short positions must be made:
- to the relevant regulator (privately):
- when the position exceeds 0.2%of share capital;
- if the net short position falls below that level, or increases – notifications must be made at additional increments of 0.1% up until 0.5% of share capital
This will enable regulators to monitor and investigate short selling that may create systematic risks or be abusive.
- to the market when net equity short positions exceed 0.5%of share capital, with additional disclosure required at 0.1% increments, with the aim of increasing transparency to other market participants.
- The regulation also provides for notifications be made privately to the relevant regulator of:
- significant net short positions in sovereign debt; and
- uncovered positions in CDS related to sovereign issuers.
Each national regulator will separately decide on the appropriate disclosure point and incremental disclosure levels for short positions in sovereign debt. The rule covers debt issued by the EU, by Member States, and by any ministry, department, central bank, agency or instrumentality that issues debt on behalf of a Member State. Regional bodies and quasi-public bodies that issue debt are outside the scope of this requirement.
Net short positions will be calculated on an entity basis as at mid-day of the relevant trading day. Disclosure must then be made by 3.30pm on the following trading day.
In calculating net short positions, entities will have to include not just direct short positions in equity, but all effective short positions created by the use of derivatives such as options, futures, contracts for difference and spread bets. The disclosure requirements do not cover bonds – the position of preference shares and convertible bonds is to be clarified.
Short sales in exchange-listed equity instruments traded on an EU trading venue would need to be appropriately marked to distinguish them from regular long sales.
Trading venues will establish the marking procedures and then publish daily information about the aggregate volume of short sales executed on the venue in each individual equity security, giving regulators reliable data on the extent of short selling of shares in Europe, to enable real time response if needed.
Ban on "naked" short sales
"Naked" short sales in equity securities and sovereign debt will be banned - short sales will only be permitted where the seller has borrowed (or entered into an agreement to borrow) the instrument or has made other arrangements to locate and reserve the security for lending. Technical standards developed by the new European Securities Market Authority (ESMA) will determine which agreements would satisfy these provisions: the practice of relying on a prime broker's "easy to borrow" list seems likely to be permitted.
Exemptions from the regime
- The proposed regime will not apply to net short positions in the equity of a company where the principal market is outside the EU. Issuers whose principal market is inside the EU are in scope even if domiciled outside the EU.
Regulators within the EU will determine the location of the principal market. At least every two years, each regulator must analyse shares traded both in their jurisdiction and outside of the EU, to determine whether the principal venue is outside the EU and will be required to notify ESMA of the shares they have identified as having a principal venue outside the EU by a specified date yet to be determined. ESMA will publish a collective list every two years, to be deemed effective from a date certain for a two-year period.
Potentially, this means that a company could change its main trading venue within the two-year period and its securities would be exempt from the regulations for the remainder of the two-year cycle until ESMA's list is updated. This loophole may be addressed in the coming months, and some are already lobbying for more frequent tests be put in place.
- There is an exemption for market makers - defined as those entities that either (a) post firm, simultaneous two-way quotes of comparable size and at competitive prices, with the result of providing liquidity on a regular and ongoing basis to the market, and/or (b) fulfil orders initiated by clients as part of their usual business, and hedge positions arising out of those dealings.
Authorised primary dealers, dealing as principal in financial instruments in order to assist issuers of sovereign debt, would also be exempt from the relevant notification rules and the restrictions on naked short sales. Primary dealers are also exempt from the notification, equity marking and naked short selling requirements where acting in relation to a stabilisation scheme.
To qualify for this exemption, market makers and primary dealers must notify the regulator of their home member state (or if they are located in a third country, the regulator of their main EU trading venue) at least 30 days in advance, and will be required to respond promptly to information requests related to trading under the exemption. ESMA will publish list of exempted parties on its web site.
Trading venues, and central counterparties that provide clearing services to the trading venue, will have to ensure that there are adequate arrangements for buy-in of securities where there is a failure to settle a transaction - in the case of shares or sovereign debt, if the instruments are not delivered for settlement within four days after the trading day (T+4), or six days after the trading day in the case of a market maker (T+6).
If neither the trading venue nor the central counterparty is able to buy-in the securities for delivery, then cash compensation must be paid by the trading venue or counterparty to the buyer based on the value of the securities at the delivery date, plus reimbursement for any related losses incurred by the buyer. The entity that caused the failure will be required to reimburse the trading venue or central counterparty.
Trading venues (or, where appropriate, settlement systems) will be required to impose daily fines for settlement failures which are high enough to act as a deterrent, and must be able to ban those who have failed to settle in the past from entering into further trades.
In the case of a significant fall in the price of a financial instrument on a trading venue, the relevant regulator of the home Member State for that venue would be able to impose a 24-hour prohibition on short selling of the instrument. In the case of shares, a fall in value of 10% or more would trigger the power; criteria for other classes of financial instruments will be set through technical standards.
In the event of a serious threat to financial stability, regulators would have exceptional powers for up to three months (which period can be extended for further periods of three months at a time), to:
- prohibit or impose restrictions on short selling, CDS and other transactions that accomplish the same effect as a short sale – these could prevent market making and primary market activities;
- require private or public disclosure of net short positions in instruments that are currently exempt for an unlimited period of time as necessary to address a relevant threat.
Proposed use of any such measures must be notified ESMA and other regulators, and could only take effect once published on the regulator's web site. ESMA will coordinate intervention measures by different authorities. Various requirements aimed at ensuring and enhancing cooperation amongst regulatory authorities are also proposed.
In a financial emergency, ESMA will also have overriding powers to demand disclosure of short positions or intervene to bar or limit short selling, CDS trading, or other financial instruments for a period of three months, where the situation has cross border implications and regulators have not adequately addressed the threat.
Member States and their regulators will provide rules on administrative measures, enforcement powers, sanctions and pecuniary measures, including powers to make document, telephone, data records and other information requests, demand appearances of relevant persons, bring enforcement actions, and freeze assets.
Specifically, regulators will be able to request further information about the purpose for which a CDS is entered into and information verifying that purpose directly from natural or legal persons. For traders who trade quickly and often, this could impose a significant compliance burden.
The proposal will now pass to the European Parliament and the Council for adoption. Once adopted, the regulation would apply from 1 July 2012. Technical standards will be submitted by ESMA by the end of 2011. Once the Commission endorses the technical standards, they will be binding on Member States, without the need for further legislation.