With the recent publication of two further delegated regulations, the final pieces are almost in place for the EU Regulation on short selling and certain aspects of credit default swaps (236/2012/EC) to take effect on 1 November 2012. Once in force, the Regulation will have direct effect across all EEA member states. For the first time, therefore, the rules on short selling will become harmonised across the region.
With the recent publication of two further delegated regulations, the final pieces are almost in place for the EU Regulation on short selling and certain aspects of credit default swaps (236/2012/EC) (the Regulation) to take effect on 1 November 2012 (see box "Short selling"). The Regulation is complemented by four delegated or implementing measures which flesh out some of the more technical aspects of the rules.
Once in force, the Regulation will have direct effect across all EEA member states. For the first time, therefore, the rules on short selling will become harmonised across the region.
The Regulation requires firms to disclose short positions in relation to shares and EU sovereign debt.
Shares. The Regulation provides for a two-tier model of private and public reporting at initial and incremental thresholds, triggered by the size of a net short position in shares:
A net short position of 0.2% or more in the issued share capital of a company admitted to trading on a regulated market or multilateral trading facility must be reported privately to the home member state regulator of the relevant issuer for the purposes of the Transparency Directive (2004/109/EC).
Additional reports must be made if the short position reaches each 0.1% threshold thereafter (that is, at 0.3%, 0.4%, 0.5% and so on). A report must also be made when the firm's net short position falls below these thresholds.
On reaching 0.5% of the issued share capital, and each 0.1% threshold thereafter, the net short position must be reported to the market.
This expands on the existing disclosure requirements under the Financial Services Authority's short selling regime (set out in the Financial Stability and Market Confidence sourcebook (FINMAR)), which currently apply only to net short positions in shares that are the subject of a rights issue and in shares in UK financial sector companies.
Sovereign debt. The Regulation requires firms to report to regulators certain net short positions in EU sovereign debt, including positions in credit default swaps (CDS) referencing an EU sovereign debt obligation. Sovereign debt instruments issued by any member state, the EU itself, the European Financial Stability Facility and the European Investment Bank are covered.
There are two categories of threshold (based on the size of the outstanding issued sovereign debt and the liquidity of the sovereign debt market measured in terms of total turnover):
An initial reporting threshold of 0.1% (and 0.05% intervals thereafter) applies to member states where the total amount of the outstanding issued sovereign debt is up to €500 billion.
A reporting threshold of 0.5% (and 0.25% intervals) applies if the total amount of the outstanding issued sovereign debt is more than €500 billion, or if there is a "liquid futures market" for the particular sovereign debt.
The monetary amounts implied by the relevant percentage thresholds for each sovereign issuer will be published quarterly by the European Securities and Markets Authority (ESMA).
From November 2012, a firm that wishes to take an uncovered, or "naked", short position in particular shares (see box "Short selling") must have done one of the following:
Borrowed sufficient shares to settle the trade;
Entered into a binding agreement to borrow those shares (these include futures, options and repurchase agreements); or
Entered into an arrangement with a third party under which that third party has confirmed that the shares have been located, and taken measures vis-à-vis third parties necessary for the firm to have a reasonable expectation that settlement can be effected when it is due. The implementing measures elaborate on "locating a share" and the measures that could legitimately give rise to a "reasonable expectation" that settlement can be effected.
The Regulation is marginally less prescriptive in relation to uncovered short or CDS positions in sovereign debt.
An uncovered short position in sovereign debt is permitted if it is used to hedge a long position in the debt instruments of an issuer, the pricing of which has a "high correlation" with the pricing of the sovereign debt. This is a different, and arguably more commercially unrealistic, standard compared to the simple correlation prescribed for sovereign CDS. Some firms will need to consider carefully the extent to which they can hedge their risk exposures to sovereign debt without breaching the Regulation. The delegated measures expand on when uncovered short positions can amount to a valid hedging technique.
In contrast, firms are not permitted to enter into an uncovered CDS on sovereign debt unless there is an "insurable interest" in the underlying sovereign debt position.
Under the Regulation, central counterparties (CCPs) are required to have automatic buy-in arrangements which will be triggered if short-sold shares are not delivered within four business days after the settlement date. Where buy-in is impossible, the Regulation provides that the short seller must instead pay an amount to the buyer based on the value of the shares and the losses incurred by the buyer due to settlement failure. The short seller must also reimburse the CCP for the cost of effecting any buy-in or cash compensation.
The Regulation also mandates that settlement failures on shorts should attract daily fines (imposed by CCPs) that are sufficiently high to act as a deterrent to settlement failure. It is not yet clear how the level of these fines will be set and how they will be enforced if the relevant short seller does not have operations in the jurisdiction concerned.
CCPs are likely to impose additional margining or other default requirements to address the risk that they may otherwise fail to recover amounts imposed in respect of settlement failures from clearing members.
The Regulation is a welcome move towards harmonisation of the (currently) disparate approach to the regulation of short selling. Also welcome are the new powers for regulators to take certain measures in exceptional circumstances, including to require further transparency or impose temporary bans on short selling and CDS transactions in their jurisdictions, for an initial three-month period.
In addition, ESMA is required, within 24 hours of notification that a measure is to be imposed or renewed, to issue an opinion assessing its necessity, appropriateness and proportionality as well as whether any measure should also be taken by other regulators.
In relation to financial instruments other than sovereign debt or CDS, ESMA may intervene if it considers there to be a threat to the orderly functioning or stability of the markets, or other "cross-border implications" which are unaddressed, or insufficiently addressed, by national measures. A measure taken by ESMA in this context would prevail over any previous measures taken by a national regulator.
This means that ESMA could seek to take direct control of the regulation of short selling in individual member state markets, even in circumstances where the national regulator does not agree that a ban is necessary (and may even be of the view that a ban would be counter-productive).
Selmin Hakki is an associate, and Ben Kingsley and Jan Putnis are partners, in the Financial Regulation Group at Slaughter and May. This article has been extracted from a more detailed paper available at www.slaughterandmay.com containing an analysis of the EU short selling regime as well as a series of questions and answers.
A "short sale" is defined in the EU Regulation on short selling and certain aspects of credit default swaps (236/2012/EC) as any sale of a share or debt instrument which the seller does not own at the time of entering into the agreement to sell, including where the seller has borrowed or agreed to borrow the share or debt instrument for delivery at settlement. The definition excludes sales under a repurchase agreement, transfers of securities under a securities lending agreement and futures contracts.
In general terms, short selling is the practice of selling securities not owned by the seller in the hope that the price subsequently falls and they can then be bought back at a lower price. The seller may have borrowed the necessary securities on a temporary basis in order to deliver the stock to the buyer, or may not hold them at all (referred to as a naked short). In both cases, the related security must be purchased at a later stage to close out the transaction.