EU to Regulate Short Selling

The Commission has proposed a Regulation that it says will create a harmonised EU regulatory framework for short selling and credit default swaps (CDS). It would, amongst many things, give Member States and the European Securities and Markets Authority (ESMA) the power to restrict the practice of short selling and CDS trading and, says the Commission, ensure more transparency. In addition to creating a more coherent financial regulatory system, one of the main stated aims of this proposal is to increase regulatory convergence between the EU and other major economies that have enacted similar rules.

The EU is today fragmented into different national regulatory frameworks concerning short selling and CDS; some countries in the EU have put into force various restrictions whereas others have not. With a number of EU Member State governments blaming short selling for exacerbating the recent sovereign-debt crisis in Europe, political pressure had grown for the Commission to come forward with EU-wide regulatory proposal. EU Issue Tracker provides an overview.

Financial instruments covered

The proposal would be applicable to all financial instruments that are traded on trading venues and when those instruments are traded outside trading venues within the EU. It would also include derivatives relating to certain financial instruments or debt instruments created by Member States or the EU.

Whom will it apply to?

The proposed regulation would apply to all natural or legal persons who, in relation to all markets, engage in short selling and it would be independent of whether these actors are already regulated or unregulated. Rather than focusing on intermediaries, it focuses specifically on the actors who enter into the trading of short sales.

Short Selling and CDS

The proposal stipulates that since the current fragmented regulatory landscape concerning short selling and CDS may impede the effectiveness of national measures that have been implemented, impose extra costs and create problems for investors and open up the possibility for regulatory arbitrage, a coherent EU regulatory framework will be of great importance in order to address these issues so as to create a more effective regulatory system. The reason for including CDS in the proposal is because it has some characteristics that are similar to that of short selling. However, in regards to short selling in particular, the proposal outlines three specific measures that will deal with the risks relating to it:

Increasing transparency

This is neededn, says the Commission, to ensure that regulators can detect any potential systemic risk that could come about as a result of short selling. Specifically, the proposal would require: 
• More transparency as concerns both legal and natural persons that have either short positions relating to EU sovereign debt and shares and/or substantial CDS positions in regards to EU sovereign debt issuers. It would allow for a two tier system of transparency for substantial net short positions in shares for corporations that have their shares traded on a trading venue within the EU.  
• If the short position is low rather than big (this is defined by a notification threshold that relates to a situation when a position falls below 0.2% of the value of the issued share capital of a corporation and each 0.1% above that), the corporation would have to notify the regulator of its positions, whereas in the opposite situation (i.e. when it is above the threshold) it would have to disclose its position to the market as well. This is done in order to address the issues of systemic risk and abusive practices relating to short selling. Similar conditions would be applied to substantial net short positions of sovereign EU debt and CDS since such positions would have to be disclosed to regulators. 
• Were there to be a shift in net short positions from higher to lower levels the regulators would also have to be informed about that. 
• The issue of transparency does also apply to positions taken outside trading venues and encompasses net short positions created by the use of derivatives such as futures, options, contracts for differences and spread bets concerning sovereign debt and shares. 
• In addition to all of these transparency initiatives the proposal would also include a requirement for the marking of short orders (i.e. sell orders carried out on trading venues being marked or flagged as short orders when a seller carries out a short sale of shares on a trading venue). This is done to ensure that additional information will be provided about the quantity of short sales engaged in on the trading venue. 

Minimising settlement failure and its accompanying risks

The practice of uncovered (or ‘naked’) short selling (i.e. when a seller has not borrowed a product being traded, nor has signed an agreement to do so, but still trades it) is considered by many to increase the likelihood of sellers not being able to settle their financial obligations. Thus the proposal makes clear:
• That the seller must have borrowed the product in question or entered into an agreement that makes clear that either the seller will borrow the product or ensure that the product will be at hand by the date of the settlement. 
• In cases where settling a transaction is not possible, sufficiently good arrangements that allow for buy-in of sovereign debt and shares must be ensured by the trading venue. 
• If a failure of settlement occurs daily fines will be imposed.
• Natural or legal persons who have been involved in a settlement failure could be banned by the trading venue to engage in future short sales.    

Limiting the effects of price falls

This is needed to ensure that price falls, precipitated by short selling, do not lead to systemic risk (see below for more details).

Intervention in markets: The proposal stipulates that:
• All Member States would be given the power to restrict and to ensure more transparency in regards to short selling, CDS and derivatives transactions during exceptional circumstances. Such measures would be allowed for a finite period of three months (with the possibility to extend the time period). 
• To know when such measures can be put into force, the Commission will be given the power to define the criteria that need to be fulfilled before doing so. In addition to this, Member States will also be given the power to restrict the practice of short selling if there is a substantial price fall of a financial product or a class of financial products.
• The European Securities and Markets Authority (ESMA, which will not start operating before January 2011) will play an important role when these measures are being enacted by Member states. Not only will ESMA play an important role in coordinating the activities of the Member States but it will also be able to take the same measures as the Member States (its decisions will override any measure taken by Member States that are inconsistent with the ones taken by ESMA) if there is systemic risk within the EU and the actions taken by the Member States are deemed to be insufficient.

International coordination

Although not identical to one another, the proposal goes a long way to harmonise EU regulation with that of the U.S. (and Hong Kong) which is important to prevent any harmful regulatory arbitrage by market participants.

Exemptions will be given to market making activities, primary market operations and shares that are traded mainly outside of the EU. The reason for this is that not having these exemptions would be detrimental to the aim of keeping markets liquid, having functioning primary markets and would be disproportionate (in relation to shares being mainly traded outside the EU).

Powers and sanctions

In addition to the Member States’ and the EU’s powers being created as part of this proposal, it also ensures that:
• To enforce the rules, Member states will be allowed to gather all the relevant information and documents needed from natural or legal persons to enforce the law. They can also request to be given information about the different actors purpose to engage in a CDS transaction.
• There should be greater focus in securing cooperation between EU regulators and regulators in non-EU states where EU bonds, shares (and derivatives based on these) are traded so that EU regulators can monitor companies and individuals outside the EU. 

Next steps

The proposal has now been sent to the European Parliament and the Council, which will have to vote on it before it becomes law. If it is adopted it will become law on 1 July 2012. Also, the upcoming proposal to revise the Markets in Financial Instruments Directive in 2011 may further add to the EU’s capability to address systemic risks within the EU. A possible revision of the Market abuse Directive could also give the EU the power to address certain types of market manipulation.