Brussels, 15 September 2010
New framework to increase transparency and ensure coordination for short selling and Credit Default Swaps
The European Commission today adopted a proposal for a regulation on short selling and certain aspects of Credit Default Swaps (CDS). Its main objectives are to create a harmonised framework for coordinated action at European level, increase transparency and reduce risks. The new framework will mean regulators – national and European - have clear powers to act when necessary, whilst preventing market fragmentation and ensuring the smooth functioning of the internal market.
Internal Market and Services Commissioner Michel Barnier said: "In normal times, short selling enhances market liquidity and contributes to efficient pricing. But in distressed markets, short selling can amplify price falls, leading to disorderly markets and systemic risks. Today’s proposal will increase transparency for regulators and markets, and make it easier for regulators to detect risk in sovereign debt markets. Regulators will also gain clear powers to restrict or ban short selling in exceptional situations, in coordination with the new European Securities and Markets Authority (ESMA). Today's proposals are a further step towards greater financial stability in Europe."
Short selling is the sale of a security the seller does not own with the intention of buying it back at a later point in time in order to deliver it. Naked short selling is where the seller has not borrowed the securities, or ensured they can be borrowed before settlement prior to the short sale. It can lead to specific risks of settlement failure (i.e. not completing the transaction). Since the onset of the financial crisis, many Member States have taken actions to suspend or ban short-selling. Uncoordinated actions can be less effective and lead to difficulties on the market, including impacting on investor confidence.
At present, there is little reliable information available on short selling: it is difficult for market participants and regulators to know which securities are being traded "short" and their overall significance. Today’s proposal enhances transparency by requiring that all share orders on trading venues be marked as 'short' (so-called "flagging") if they involve a short sale, so that regulators know which transactions are short. In addition, investors will have to disclose significant net short positions in shares to regulators at one threshold (0.2% of issued share capital), and to the market at a higher threshold (0.5%). These measures will mean market participants are better informed whilst allowing regulators to monitor markets and detect developing risk. Concerning sovereign bonds, regulators will be better able to detect possible risks to the stability of sovereign debt markets by receiving data on short positions, including those obtained through sovereign Credit Default Swaps (a derivative sometimes regarded as a form of insurance against the risk of default).
Clear powers for regulators and a coordinated European framework
In distressed markets, transparency alone may not be enough. At present, the powers that national regulators have to restrict or ban short selling vary greatly between Member States. Today's proposal gives national regulators clear powers in exceptional situations to temporarily restrict or ban short selling in any financial instrument, subject to coordination by ESMA (which should be operational from January 2011 subject to agreement by the European Parliament). ESMA is also given the power to issue opinions to competent authorities when they intervene in exceptional situations. In line with the new supervision framework, ESMA will have the possibility, when certain conditions are fulfilled, to adopt temporary measures itself, with direct effect, restricting or prohibiting short selling.
In addition, if the price of a financial instrument falls by a significant amount in a day, national regulators will have the power to restrict short selling in that instrument until the end of the next trading day. These measures will help regulators take the necessary action, in a coordinated way, to slow or halt price declines which can be amplified by short selling in distressed markets. They will also reduce compliance costs for market participants which currently arise from the divergence of national rules.
Tackling the specific risks of naked short selling
Naked short selling potentially increases the risk of settlement failure. Today's proposal requires that to enter a short sale, an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party to locate and reserve them for lending so that they are delivered by the settlement date [at the latest 4 days after the transaction]. Trading venues must ensure that there are adequate arrangements in place for buy-in of shares or sovereign debt, as well as fines and a ban on short selling, where there is a settlement failure.
Certain exemptions are included in the proposal – for example for some defined activities which play an important role in providing liquidity or are essential to the proper functioning of primary bond markets.
The proposal now passes to the European Parliament and the Council for negotiation and adoption. Once adopted the regulation would apply from 1 July 2012.