ABBL

In February 2010, the Committee of European Securities Regulators (CESR) published a report recommending pan European rules requiring the notification and disclosure of significant net short positions in EU shares. It urged the Commission to introduce legislation as soon as possible implementing these requirements.

Separately, in the context of the Greek government bonds there has been much debate about whether speculation in credit default swaps (CDS) led to an unjustified the widening of spreads in the government bonds and had an adverse affect on the sovereign bond market. The Commission services have therefore set up a taskforce to examine whether there has been any link between speculation in CDS and the underlying bond markets. Although raising different issues to short selling, if measures restricting speculation in CDS are considered appropriate they could be included in the short selling initiative (as an analogy can be drawn between speculation in CDS and naked short selling of shares).

The European Commission said on 9 March it will consider banning 'naked' selling of derivatives contracts and Greece said curbs on speculators would be examined by the G20 powers.

The main policy objectives are:

• To reduce systemic risks and disorderly trading involving short selling,
• To facilitate monitoring and, if necessary, enforcement against short selling that may involve market abuse,
• To reduce information asymmetry between market participants arising from short selling,
• To reduce the risk of settlement failure due to uncovered short selling,
• To prevent speculation in CDS having an adverse effect on government bond markets.

A high level consultation on the possibility of introducing short selling measures was launched in June 2010. Below, you find ABBL &  EBF responses.

(Source: European Commission/EurActiv)

A Credit Default Swap (CDS) is a derivative which is sometimes regarded as a form of insurance against the risk of credit default of a corporate or government (or sovereign) bond. In return for an annual premium, the buyer of a CDS is protected against the risk of default of the reference entity (stated in the contract) by the seller. If the reference entity defaults, the protection seller compensates the buyer for the cost of default.

In addition to short selling on cash markets, a net short position can also be achieved by the use of derivatives, including Credit Default Swaps (CDS). For example, if an investor buys a CDS without being exposed to the credit risk of the underlying bond issuer (a so-called "naked CDS"), he is expecting, and potentially gaining from, rising credit risk. This is equivalent to short selling the underlying bond.

MEMO/11/713 - 19 October 2011, European Commission

During the financial crisis and more recently in the context of market volatility in euro denominated sovereign bonds, Member States reacted differently to the issues raised by short selling and credit default swaps. A variety of measures have been adopted using different powers by some Member States while others have not taken action. There is currently no legislative framework at European level to deal with these issues in a coherent way. A fragmented approach to these issues can limit the effectiveness of the measures imposed, lead to regulatory arbitrage (which basically means shopping around for the least onerous regime) and create additional costs and difficulties for investors.

While the Commission acknowledges that short selling has economic benefits and contributes to the efficiency of EU markets, notably in terms of increasing market liquidity, more efficient price discovery and helping to mitigate overpricing of securities, it also presents risks.

While reducing the scope for regulatory arbitrage and compliance costs arising from a fragmented regulatory framework, the three main risks of short selling which the Commission sought to address in the Regulation are:

    •    transparency deficiencies: the current lack of transparency in relation to short selling prevents regulators from being able to detect at an early stage the development of short positions which may cause risks to financial stability or market integrity. Greater transparency to the market on short selling would deter aggressive short selling and give useful information to the market about how short sellers view the performance and prospects of companies.
    •    the risk of negative price spirals: many regulators have expressed concerns about the risks of short selling amplifying price falls in distressed markets, and that this could lead to systemic risks. It was due to these concerns that a number of Member States introduced emergency measures to restrict or ban short selling in some or all shares in autumn 2008. Concerns have also been expressed by some Member States that short positions through CDS transactions could in some circumstances contribute to a decline of sovereign bond prices.
    •    the risks of settlement failure associated with naked short selling: when a short seller sells a financial instrument short without first borrowing the instrument, entering into an agreement to borrow it, or locating the instrument so that it is reserved for borrowing prior to settlement ("naked short selling"), there is a risk of settlement failure. Some regulators consider that this could endanger the stability of the financial system, as in principle a naked short seller can sell an unlimited number of shares in a very short space of time.


The Regulation agreed by the European Parliament and Council addresses both short selling and CDS because CDS can be used to secure a position economically equivalent to a short position in the underlying bonds. The buyer of a naked CDS benefits from the deterioration of the credit risk of the issuer in a very similar manner to the benefit which the seller of the bonds derives from this same deterioration which decreases the prices of the bonds.

MEMO/11/713 - 19 October 2011, European Commission
 

Transparency is key in ensuring the efficient functioning and monitoring of financial markets. So the Regulation provides for several measures to enhance transparency in short selling for shares and government debt.

- for shares:
For EU shares the provisions to enhance transparency are largely based on the two tier model recommended by CESR (the Committee of European Securities Regulators, the predecessor of ESMA) in its report in March 2010. At a lower threshold (0.2% of the issued share capital) notification of a short position will be made only to the regulator and at a higher threshold (0.5%) short positions will be disclosed to the market. Notification to regulators will enable them to monitor and, if necessary, investigate short selling that may pose systemic risks or be abusive. Publication of information to the market will provide useful information to other market users and act as a disincentive to aggressive short selling strategies.
The Regulation also calls for consideration to be given by the Commission, in the context of the revision of the Markets in Financial Instruments Directive (MiFID), to whether inclusion by investment firms of information about short sales in transaction reports to competent authorities would provide useful supplementary information to enable competent authorities to monitor levels of short selling.

- for sovereign bonds:
A specific regime for notification to regulators only of significant net short positions in EU sovereign bonds is set out in the Regulation. This includes notification of significant credit default swap positions relating to sovereign debt issuers. Disclosure to regulators of significant net short positions relating to EU sovereign bonds will provide important information to assist regulators to monitor whether such positions are creating disorderly markets or systemic risks or are being used for abusive purposes. The provisions on sovereign bonds provide for information to be disclosed only to regulators rather than to the market, as public disclosure could have negative consequences for the operation of sovereign bond markets, notably in terms of liquidity. The evidence from the existing short selling disclosure regimes for shares at national level is that these have not had an undue impact on the liquidity of share markets.
In order to avoid any circumvention of the short selling disclosure rules through off-exchange derivative transactions, the transparency requirements for EU shares and EU sovereign bonds also cover the use of derivatives to obtain a net short position relating to the shares or bonds. The Regulation also requires that short positions should be subtracted (or 'netted off') from long positions, as notification of a net short position provides more meaningful information to regulators and/or the market.

MEMO/11/713 - 19 October 2011, European Commission
 

ESMA is given an important role in coordinating action in exceptional situations. Competent authorities must notify ESMA of the measures they propose to take (or renew) in such a situation, not less than 24 hours before the entry into force of the measures (this period may be shorter in exceptional circumstances). ESMA shall consider the information received and issue an opinion (within 24 hours) on whether the measure or proposed measure is appropriate and proportionate to address the threat, and whether measures by other competent authorities are necessary. Where a competent authority takes action contrary to ESMA's opinion it shall publish a notice giving its reasons for doing so. In such a situation ESMA shall consider whether the conditions are met for it to use its powers of intervention.

In relation to financial instruments other than sovereign debt or sovereign CDS, 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 Union and there are cross border implications; and measures have not been taken by competent authorities, or are not sufficient, to address the threat.

The measures which ESMA can take and the requirements to notify regulators are the same as those foreseen for national competent authorities. When taking a measure, ESMA shall consider the extent to which the measure will significantly address the threat, will not create a risk of regulatory arbitrage and will not have a detrimental effect on the efficiency of financial markets that is disproportionate to the benefits of the measure.

A measure adopted by ESMA in accordance with its powers of intervention shall prevail over any previous measures taken by a competent authority.
In the case of an emergency situation related to sovereign debt or sovereign CDS, Articles 18 and 38 of the ESMA Regulation shall apply. These articles empower ESMA to act when Council declares an emergency situation, subject to the fiscal safeguard clause (article 38).

MEMO/11/713 - 19 October 2011, European Commission

The proposal provides for competent authorities to have all the powers necessary, as well as rules on administrative measures, sanctions and pecuniary measures, to enforce the proposals. ESMA is also given the power to conduct inquiries into specific issues or practices relating to short selling and to publish a report setting out its findings. As certain measures may involve monitoring or enforcement against persons outside the European Union, EU regulators are required to reach cooperation agreements with regulators in third countries where EU shares or sovereign bonds and associated derivatives are traded.

MEMO/11/713 - 19 October 2011, European Commission
 

The Regulation bans naked sovereign CDS, under the conditions described below, to address concerns that naked sovereign CDS can destabilize the sovereign debt markets in a similar way to short selling.

A "naked" sovereign CDS refers to the situation where the CDS is acquired by the buyer not to hedge against the risk of default of the sovereign issuer where the buyer has a long position in the sovereign debt of that issuer, or the risk of a decline of the value of the sovereign debt where the buyer of the CDS holds assets or is subject to liabilities the value of which is correlated to the value of the sovereign debt. In other words, the buyer of the CDS is "naked" if he does not have an exposure which he is seeking to hedge either to the sovereign debt itself, or to assets or liabilities whose value is correlated to the sovereign debt.

The assets or liabilities are broadly defined to include financial contracts, a portfolio of assets or financial obligations. Exposures to a sovereign which shall not be considered a "naked" CDS include any exposures to the central, regional and local administration, public sector entities or any exposure guaranteed by any referred entity. Furthermore, exposure to private sector entities established in the Member State should be also included. All exposures shall be considered in this context including among others loans, counterparty credit risk (including potential exposure when regulatory capital is required to such exposure), receivables and guarantees. It also includes indirect exposures to any of the referred entities obtained through among others exposure to indices, funds or special purpose vehicles.

The Regulation includes a requirement for a permanent ban on naked CDS, in order to address the risk that such positions could have a destabilising effect on sovereign debt markets. However, in order to address concerns that such restrictions could negatively affect the liquidity of sovereign debt markets, a competent authority may temporarily suspend the restrictions where it believes, based on objective elements, that its sovereign debt market is not functioning properly and that such restrictions might have a negative impact on the sovereign credit default swap market, especially by increasing the cost of borrowing for sovereign issuers or affecting the sovereign issuer's ability to issue new debt.

These objective elements shall be based on the following indicators:

    •    high or rising interest rate on the sovereign debt;
    •    widening of interest rate spreads on the sovereign debt compared to the sovereign debt of other sovereign issuers;
    •    widening of the sovereign credit default swaps spreads compared to the own curve and compared to other sovereign issuers;
    •    timeliness of the return of the price of the sovereign debt to its original equilibrium after a large trade;
    •    amounts of sovereign debt that can be traded.

A competent authority may use additional indicators to those set out above. Prior to suspending the restrictions, a competent authority shall notify ESMA and other competent authorities about the intended suspension or renewal of the suspension and the objective elements on which it is based.

ESMA shall issue an opinion within 24 hours on the intended suspension and where this is based on an indicator other than those listed above, shall include in its opinion an assessment of the indicator. The ban on naked CDS can be suspended for an initial period not exceeding 12 months, renewable for further periods of up to 6 months if the grounds for suspension continue to be applicable.

MEMO/11/713 - 19 October 2011, European Commission
 

Having been agreed by the European Parliament, the Council and the Commission in the trilogue, the Regulation now has to be adopted in its agreed, amended form by the European Parliament in first reading. This adoption is expected to take place during the plenary session of 24-27 October.

The Council must then adopt the Regulation in exactly the same amended form at a subsequent meeting. Once adopted by the European Parliament and the Council, the text will then be finalised in all languages by the legal linguists before being published in the Official Journal. Publication is expected to take place by 1 January 2012. The Regulation is expected to enter into force in November 2012], by which time the Commission delegated acts and implementing and regulatory technical standards of ESMA will have to be adopted.

MEMO/11/713 - 19 October 2011, European Commission