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The European Commission has released a formal proposal for a pan-European short selling regime, including short selling of sovereign debt credit default swaps. The proposed regime is expected to become law in each Member State of the European Union by 1 July, 2012.
Background to the Proposal
On 15 September, 2010, the European Commission (the "Commission") adopted a proposal (the "Proposal") for a Regulation on short selling and certain aspects of credit default swaps ("CDS").1 The Proposal aims to replace a patchwork of national short selling regimes promulgated by various European Union ("EU") Member States and create a harmonised framework for coordinated action on short selling and sovereign CDS at the EU level.
Over the past two years, various EU Members States have adopted measures to curb short selling within their individual jurisdictions, ranging from an absolute ban on short selling in certain financial instruments, to a ban on naked short trades, to requirements for the disclosure of net short positions. Often these measures were brought into effect with little or no advance notice to market participants in the exercise of the emergency powers granted by national legislation in the wake of the financial crisis. In some cases, such emergency measures attracted severe criticism from the investment community and other regulators around the world. The scope of the instruments (especially, in the case of derivatives) covered by these regimes varied significantly amongst Member States and, at times, the regulatory guidance clarifying the application of the regulations was released weeks after the measures became law.
Since September 2008 the Committee of European Securities Regulators ("CESR") has produced regular updates on short selling measures adopted by EU Member State regulators.2 Following repeated calls from EU Member State regulators and market participants to adopt a uniform approach to short selling, in March 2010, CESR produced a report with proposals for a pan-European short selling disclosure regime.3 In broad terms, the report introduced a two-tier approach to disclosure of net short positions:
- at a lower threshold (0.2%), net short positions were to be disclosed to the relevant EU Member State regulator; and
- at a higher threshold (0.5%) net short positions were to be disclosed to the whole of the market.
In May 2010, following the introduction of an emergency ban on naked short selling in sovereign debt issued by Member States within the Eurozone and CDS relating to such sovereign debt by the German regulator BaFin, questions were raised as to both the necessity of coordinated action by the EU in relation to short selling of sovereign CDS and the scope of emergency intervention powers which can be exercised by national regulators of EU Member States unilaterally. In June 2010, the Commission responded to the debate by launching a public consultation4 on EU legislation on short selling which set out the basis for the Proposal.
Scope of the Proposal
Subject to the exemptions below, the Proposal applies to:
- all financial instruments which are admitted to trading on a "trading venue" in the EU;
- any derivatives relating to such financial instruments or the issuers of such financial instruments (e.g. CDS); and
- sovereign debt instruments issued by the EU or any EU Member State and derivatives relating to such sovereign debt instruments or to obligations of the EU or any Member State generally.
A "trading venue" is defined as an EU regulated market (e.g. the main markets of the London Stock Exchange or Luxembourg Stock Exchange) or a multi-lateral trading facility (e.g. Chi-X, NASDAQ OMX Europe).
The notification and disclosure obligations set out in the Proposal (described below) will apply to all persons trading the covered instruments, whether they are in the EU or outside the EU and regardless of whether the relevant financial instruments are traded on or outside a trading venue.
The restrictions set out in the Proposal do not, however, extend to shares of an issuer admitted to trading on an EU trading venue but where the principal venue for trading the shares is located in a jurisdiction outside the EU. The Proposal contemplates that the European Securities and Markets Authority (a newly created pan-European supervisory body) ("ESMA") will publish a list of such shares every two years.
The Proposal also includes exemptions for investment firms engaged in market making or primary market operations. Investment firms located in jurisdictions outside the EU will only benefit from these exemptions if the Commission declares the legal and supervisory framework applicable to such firms in the jurisdiction of their establishment to be equivalent to the EU regulatory regime.
Notification and disclosure rules
The draft rules on disclosure for shares are largely based on the two tier model recommended by CESR (see above):
- at 0.2% of the issued share capital, the notification of a net short position would be made only to the relevant Member State regulator; and
- at 0.5% and above, net short positions would be disclosed to the whole of the market through a regulatory information service appointed by the relevant Member State.
In both cases, a notification must be made whenever the net short position reaches or falls below the relevant thresholds.
During the consultation period, concerns were raised by industry participants5 with respect to both the proportionality and the potentially damaging effects of both disclosure requirements. It was argued that at the lower threshold of 0.2%, the regulators would be flooded with notifications which will serve little or no use in assessing the systemic risk presented by short selling. At the same time, the public disclosure of short positions at 0.5% might mislead the general public, as certain critical information about associated positions would not be disseminated through public disclosure. Such disclosure has the potential of creating the erroneous perception that a particular security's price could be declining when, in fact, the short position may be a simple hedge or an investment strategy requirement. This may, in turn, significantly decrease trading volumes, interfere with efficient price discovery in affected stocks and increase intraday volatility. However, it would appear the industry's concerns have not been taken on.
In addition to the above disclosure regime, the Proposal requires that trading venues put in place procedures to ensure that persons executing sell orders in shares on a trading venue mark any short sale orders as such. The purpose of this flagging requirement is to provide the EU Member State regulators with daily statistical data about short selling volumes. (Such a flagging system is already in place at the Athens Stock Exchange in Greece.) However, this "flagging" requirement may be expensive to implement at the relevant institutions.
For sovereign debt, the Proposal requires notification of significant net short positions and uncovered positions in sovereign CDS (discussed below) to the relevant Member State regulator only. The relevant initial threshold and any incremental levels that would trigger these disclosure obligations remain to be determined by the Commission in relation to each Member State and the EU, taking into account, among other factors, the total value of outstanding issued sovereign debt for each Member State and the average size of positions held by market participants.
To prevent circumvention of the short selling disclosure rules through off-exchange derivative transactions, the transparency regimes for EU shares and sovereign debt also cover the use of derivatives to obtain net short positions (including, in the case of sovereign debt, any CDS referenced to an obligation of, or a credit event relating to, the EU or any Member State).
Uncovered sovereign debt CDS
The Proposal defines "uncovered CDS" as a transaction where a CDS is not used by the protection buyer to hedge the risk of the issuer's default (that is, where such buyer does not have a long position in the sovereign debt or a long position in the debt of an issuer for which there is a high correlation with the sovereign obligation). Further clarity on what constitutes hedging for these purposes as well as the method of calculating uncovered positions, particularly where positions are held by different entities within the same group (or by separate funds, in the case of an asset manager) will be provided by "delegated acts" to be adopted by the Commission. The Proposal does however clarify that a protection seller would not have an uncovered CDS position by reason of having an obligation to make a payment in the event of default or a specified credit event relating to the reference entity.
It is important to emphasise that the Proposal does not seek to ban uncovered sovereign CDS trading. Its stated aim is to provide greater transparency by mandating disclosure of significant naked CDS positions relating to sovereign debt issuers and thus enabling regulators to monitor whether such positions are creating disorderly markets or systemic risks.
Naked short selling
The Proposal requires investors entering into short sales of shares or sovereign debt to have borrowed the relevant financial instruments, or, as an alternative, entered into an agreement to borrow them or have an arrangement with a third party who has located and reserved them for lending, so that settlement can be effected when due. While a requirement to locate appears to be innocuous, the accompanying obligation to "reserve" the share in question raises questions of practicality. Typically a pure "locate" requirement should be capable of being met if the relevant share is clearly located at one or more sources. However, to reserve a share, which might not ultimately be required, will increase transaction costs (since the beneficial owner of the share would expect to be compensated for holding the share in reserve).
To deter settlement failures, the Proposal also requires trading venues to have adequate buy-in arrangements for shares or sovereign debt where there is a settlement failure, as well as for fines for late settlement.
The Regulation provides that, in exceptional situations, EU Member State regulators will have powers to impose temporary measures to require further transparency or to restrict short selling and CDS transactions. Specifically, Member State regulators will have the power to:
- impose a temporary ban or restrictions on the use of sovereign debt CDS;
- require market participants to publicly disclose information about their positions;
- restrict short selling and similar transactions where necessary to address a serious threat to financial stability or market confidence; and
- restrict short selling of financial instruments in the case of a significant fall in price (10% in one day) (a "circuit breaker" provision).
These powers of intervention only contemplate temporary action of up to three months. A temporary measure can be extended for further periods not exceeding three months at a time but must be fully justified. The Proposal gives ESMA a central role in coordinating action in exceptional situations and ensuring that powers are only exercised where necessary. Member State regulators are required to notify ESMA of the measures they propose to take in the above situations not less than 24 hours in advance (this period may be shorter in exceptional circumstances). ESMA will then consider the information received and issue an opinion within 24 hours on whether the measure is appropriate and proportionate to address the threat, and whether similar measures by other EU regulators may be necessary. ESMA can overrule a Member State regulator in this regard and require that the Member State regulator discontinue or modify the measures taken.
ESMA may itself take action where two conditions are fulfilled:
- there is a threat to the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the EU; and
- measures have not been taken by Member State regulators or any such measures are insufficient to address the threat.
A measure adopted by ESMA in accordance with its powers of intervention will take precedence over any previous measures taken by a Member State regulator.
What happens next?
The Proposal has been handed to the European Parliament and the Council of EU Member State finance ministers to agree the final legislative text of the Regulation. If adopted, the new regime is expected to apply from 1 July, 2012. Unlike EU Directives (the adoption of which is followed by a period - for example two years - during which the directive is transposed into national law of EU Member States), EU Regulations become law in all EU Member States as at the date specified in the Regulation.
The Commission has indicated that it intends to undertake further initiatives to regulate short selling and trading of sovereign CDS in early 2011. In particular, in the context of its review of the EU Markets in Financial Instruments Directive (MiFID), the Commission will consider further options such as transaction reporting, position reporting and the possibility of position limits which may provide additional safeguards against systemic risks. In the course of its review of the EU Market Abuse Directive, the Commission may also decide to extend the prohibition of market manipulation to all over-the-counter instruments and provide Member State regulators with new tools to sanction possible market manipulation of underlying bond markets through CDS.
For further information on the London Financial Services Regulatory Practice please contact John Casanova at +44 (0)20 7360 3739 (email:
), Leonard Ng at +44 (0)20 7360 3667 (email:
) or Anna Maleva-Otto at +44 (0)20 7360 2012 (email:
1 Proposal for a Regulation of the European Parliament and of the Council on Short Selling and Certain Aspects of Credit Default Swaps (http://ec.europa.eu/internal_market/securities/docs/short_selling/20100915_proposal_en.pdf).
2 Measures Adopted by CESR Members on Short Selling (http://www.cesr-eu.org/popup2.php?id=5238).
3 Model for a Pan-European Short Selling Disclosure Regime (http://www.cesr-eu.org/popup2.php?id=6487).
4 Public consultation on Short Selling (http://ec.europa.eu/internal_market/consultations/docs/2010/short_selling/consultation_paper_en.pdf).
5 See in particular, the Managed Funds Association's response to European Commission: http://www.managedfunds.org/downloads/MFA%20Response%20to%20European%20Commission%20Consultation%20on%20Short%20Selling.pdf.
The London Financial Services Regulatory Practice of Sidley Austin LLP
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