On 2 March 2010, the Committee of European Securities Regulators (CESR) published a report setting a proposed model for introducing a pan-European short selling disclosure regime. The prospect of a uniform European short selling regime will in principle be welcomed by firms struggling to comply with the panoply of divergent requirements presently in force.
The scope of the proposed regime is wider than the current temporary requirements to disclose net short positions, which are limited to financial stocks. There will be two tiers of disclosure, and the initial threshold for disclosure to the regulator is to be set at 0.2% of issued share capital(rather than the 0.1% initially proposed). Public disclosure of individual net short positions above 0.5% will also be required. Market making activities are to be exempted from the disclosure requirements. A number of details are still to be worked out.
CESR proposes a two-tier model for disclosure of significant individual net short positions in all shares admitted to trading on an EEA regulated market, and/or an EEA Multilateral Trading Facility, provided that the primary market of the shares is located within the EEA.
"Primary market" is not defined and it is not presently clear precisely what the test is -whether it is intended that the primary market should be the market on which the shares were first admitted to trading, the regulated market in the issuer's home state, or whether it is intended to be the most relevant market in terms of liquidity (see further below). The UK no longer has a concept of "primary listing".
- Disclosure to the regulator
Once a net short position reaches or exceeds a threshold of 0.2% of the company's issued share capital, it would be disclosed to the relevant regulator.
Any changes of position (increases or decreases) would be reported in increments of 0.1% (so when reaching or passing the thresholds at 0.2%, 0.3%, and 0.4%)
- Disclosure to the market as a whole as well as to the regulator
On reaching or exceeding a threshold of 0.5%, short positions would be disclosed to the market as a whole, in addition to the regulator.
Again, any changes of position (increases or decreases) would be reported in increments of 0.1% (so when reaching or passing the thresholds of 0.5%, 0.6%, 0.7%, etc).
- The same thresholds will apply to shares in rights issue periods
The disclosure will contain the identity of the short position holder, the identity of the issuer, the size of the position held and the date on which the position was created or was no longer held.
All financial instruments creating an economic exposure to the issued share capital of the issuer will be caught by the regime. This will therefore include positions in linked derivative contracts (both exchange-traded and OTC contracts), indices, baskets and exchange traded funds as well as short positions in cash markets.
If the primary market of the shares is located outside the EEA, the short selling regime will not apply even if the shares are admitted to trading on an EEA regulated market, and/or an EEA Multilateral Trading Facility.
The issued share capital of a company would include ordinary shares and preference shares but would exclude debt securities.
How is a net short position calculated?
In calculating whether a disclosure is required, positions which provide an economic exposure should be aggregated, subtracting any positions involving long economic exposures from the short positions. More detailed guidance about the basis for calculating exposures in relation to certain financial instruments will be required.
Positions to be reported on a T+1 basis
Disclosure reports (whether just to the regulator or to the market as well) would be made by close of business on the trading day following the day on which the relevant threshold or additional increment had been crossed.
To which regulator?
The "relevant regulator" will be the regulator of the market which is most relevant in terms of liquidity, since that is where the market impact of short selling is most significant. The rationale is that article 25(3) of MiFID already envisages that transaction reporting information will be provided to such a regulator by the other competent authorities.
The definition of the market which is the most relevant in terms of liquidity is to be found in Article 9 of the MiFID Regulation (1287/2006/EC) and the main test varies depending on the nature of the security. However, that determination can be challenged every year under Article 10 of the Regulation. Communication of the results of any such a challenge to the market will be required in order to ensure that firms can comply with their reporting requirements.
CESR intends to publish further details of its position on the mechanics of disclosure in due course.
The market maker exemption
CESR envisages that market makers, acting as liquidity providers, should be exempted from the disclosure regime, but only in respect of their market making activities. CESR is still developing its thinking on the precise definition of market maker and will publish a definition in due course.
By way of illustration of the differing provisions currently adopted by national regulators, contrast the BaFin's market maker provision with those of the AMF and the FSA:
- The BaFin exempts transactions of persons who have undertaken by contract to purchase or sell financial instruments on a continuous basis by way of trading for own account at prices defined by them to the extent that the respective transaction is necessary for the performance of such contractual obligations.
- The AMF defines market makers and liquidity providers as market members that have signed a contract for this purpose with the market undertaking, or that manage a liquidity contract signed with the issuer, or are authorised financial intermediaries in France whose regular business is to quote bid and ask prices on OTC or cash and derivative markets.
- The FSA's current indicative view on the approach to market making in the context of its own short selling regime is that a market maker is an entity that, ordinarily as part of their business, deals as principal in equities, options or derivatives (whether OTC or exchange-traded):
- to fulfil orders received from clients, in response to a client's request to trade or to hedge positions arising out of those dealings; and/or
- in a way that ordinarily has the effect of providing liquidity on a regular basis to the market on both bid and offer sides of the market in comparable size.
Trading in circumstances other than genuinely for the provision of liquidity is not exempt, and the FSA's exemption covers market makers only when, in the particular circumstances of each transaction, they are acting in that capacity. Market makers are afforded a certain level of flexibility in anticipating sales as long as this activity is genuine market making in line with its existing general levels of business. The FSA would not expect market makers to hold significant short positions, other than for brief periods. Proprietary trading strategies where the main intention is to create a short position are not market makers and are not exempt. Registration as a “market maker” with an exchange or trading platform is not relevant for the purposes of the FSA's definition.
Although CESR accepts that market makers should have some flexibility in anticipating sales, it considers the exemption would only be valid for genuine market making in line with existing general levels of business. Market makers would not be expected to hold significant short positions save for brief periods - proprietary trading would not fall within the exemption.
CESR also envisages that some regulators may wish to require financial institutions intending to rely on the exemption to notify them of their intention before making use of the exemption.
A regime distinct from market abuse
Whilst expressly acknowledging that short selling can play an important role in financial markets, contributing to efficient price discovery, increasing liquidity, facilitating hedging and other risk management activities, CESR flags concerns previously voiced by the FSA about the potential for short selling to be used in an abusive fashion and to contribute to disorderly markets. CESR believes that enhanced transparency of short selling will have informational benefits for the market.
If a permanent disclosure regime for short selling is to be effective in delivering transparency, it is critical that it should apply to the unregulated community as well as to regulated persons. There is clearly no point requiring regulated entities to disclose their short positions if, for example, hedge funds operating outside the EEA do not have to do so. It was for this reason that many CESR members opted for the market abuse regime as the mechanism for implementing their temporary measures.
One such member was the UK's FSA. Although the legal status of present short selling regime in the UK has been subject to some criticism, the foundation of the regime has not been the subject of direct legal challenge – and no enforcement action has been taken for breach of the regime. If passed, the Financial Services Bill, now in Committee stage in the House of Lords, would confer specific powers on HM Treasury and the FSA to deal with short selling, quite independently of the market abuse regime - for more detail see our briefing on the Bill.
CESR envisages that there should be separate European legislation to ensure a harmonised European approach in this area, and that EEA securities regulators should be given explicit, stand-alone powers to require disclosure in respect of short selling. CESR notes that this would provide confidence in the clarity and legal soundness of such requirements, allow for flexibility, and minimise the scope for legal challenge to the use of such powers.
Areas of potential uncertainty
In parallel to recommending that the European Institutions consider a legislative solution, CESR expects those of its members that already have powers to introduce a permanent disclosure regime to begin the process of implementing the regime. The rest are expected to aim to implement a permanent regime on a best efforts basis.
CESR clearly accepts that it will be necessary to provide further and more detailed guidance before the proposals can be implemented in a harmonised fashion. Some areas of difficulty have already been flagged above - the definition of "market maker" and "primary market", and the identification of the relevant market in terms of liquidity. When the temporary short selling regimes were put into place by the various national regulators, regulators were initially deluged with requests for clarification on a number of other significant issues. Lists of frequently asked questions were produced and regularly amended, covering a wide range of queries, such as:
- to whom the disclosure obligation applied in the case of investment managers and fund managers acting on behalf of clients (whether on a discretionary and non discretionary basis);
- whether financial instruments should be dealt with on a notional or delta adjusted basis;
- how disclosure applies across different trading desks; and
- the form of disclosure/publication.
In order to achieve the benefits of a pan-European regime, it is critical that national regulators share a common approach to the detail of the way in which the regime is applied. Given the importance of the details which still need to be worked out, it seems premature for CESR to suggest that Member States should begin implementing the regime immediately even if they have powers to do so.
BaFin forges ahead (albeit on a limited basis)
Germany's BaFin has already published some amendments to its current regime which are due to come into force on 25 March 2010, and will apply until 31 January 2011. However, this amended regime will only apply to 10 selected financial stocks, and is not fully in line with the CESR proposals.
BaFin has published a list of FAQs and a form for notifications to be submitted to BaFin. The first forms for notification (or notification and publication) of existing positions will need to be made on the first trading day after the Decree enters into force, which will be 26 March 2010.
BaFin will take charge of publication to the market, which it will make on an anonymised basis the trading day immediately following receipt of the completed form for notification and publication (T+2). Neither the name nor the domicile of the holder will be identified.