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Brussels, 19 October 2011
Regulation on Short Selling and Credit Default Swaps - Frequently asked questions
What is short selling?
Short selling is the sale of a security that the seller does not own, with the intention of buying back an identical security at a later point in time in order to be able to deliver the security. Short selling can be divided into two types:
1."Covered" short selling is where the seller has borrowed the securities, or made arrangements to ensure they can be borrowed, before the short sale.
2."Naked" or "uncovered" short selling is where the seller has not borrowed the securities at the time of the short sale, or ensured they can be borrowed.
Who engages in short selling and why?
Short selling is used by a variety of market participants including hedge funds, traditional fund managers such as pension funds and insurance companies, investment banks, market makers and individual investors. Short selling can be used for the following reasons:
What is a Credit Default Swap?
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.
Who trades in CDS and why?
There are four main groups of market participants in the CDS market: dealers, non-dealer banks, hedge funds and asset managers. The dealers are by far the largest players on the market. The aims of these market participants are diverse and they employ different strategies.
CDS can be used for the following purposes:
Why did the Commission propose legislation on short selling and CDS?
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:
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.
What are the objectives of the Regulation?
The objectives of the proposal are to:
How does the Regulation enhance the transparency of short selling?
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.
What powers will regulators have in exceptional situations?
In distressed markets when short selling can amplify a downward price spiral, transparency alone may not be enough. The Regulation provides that in exceptional situations, competent authorities (i.e. financial regulators) will have powers to impose temporary measures, such as to require further transparency or to restrict short selling and credit default swap transactions. These powers extend to a wide range of instruments. The Regulation harmonises the powers and defines the conditions and procedures that must be complied with when the powers are exercised. ESMA is given a central role in coordinating action in exceptional situations and ensuring that powers are only exercised where necessary (see section below on the role of ESMA).
The powers of intervention of competent authorities relating to short selling and credit default swaps in exceptional situations are temporary (for up to a three month period). A temporary measure can be extended for further periods not exceeding three months at a time, but this must be fully justified.
To ensure a consistent approach to the use of regulators' powers of intervention, the Commission is given the power to further define criteria for determining when an exceptional situation arises. The Commission will act by the adoption of delegated acts, and the Council and Parliament can revoke this delegation of powers or object to a delegated act within two months.
Competent authorities are also given the power, in the case of a significant fall in the price of a financial instrument on a trading venue in a single day, to impose a restriction on short selling of the financial instrument until the end of the next trading day. If despite the measure there is a further significant fall in value of the financial instrument, the competent authority may extend the measure for up to a further two trading days. Regulators imposing such a restriction shall inform ESMA. ESMA shall inform other authorities of Member States whose trading venues trade the same instrument so that they can apply the same measure. In case of disagreement, ESMA shall assist the authorities concerned to reach an agreement and if this fails, ESMA may take a decision itself in accordance with Article 19 of the ESMA Regulation ("binding mediation").
What role will ESMA have to ensure coordination in exceptional situations?
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).
What restrictions are provided for on naked short selling?
In order to reduce the risks of settlement failures and increased price volatility which can be associated with naked short selling of shares and sovereign debt, certain requirements are introduced. These are distinct for shares and for sovereign debt.
For shares: In order 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 under which that third party has confirmed that the share has been located and has taken measures vis-à-vis third parties necessary for the investor to have reasonable expectation that settlement can be effected when it is due. This is known as a 'locate rule'. ESMA shall develop draft implementing technical standards to determine the types of agreements, arrangements and measures that adequately ensure that the share will be available for settlement. In determining what measures are necessary to have a reasonable expectation that settlement can be effected when it is due, ESMA shall take into account among others intraday trading and the liquidity of the shares. To deter settlement failures, trading venues must also ensure that there are adequate arrangements in place for buy in of shares where there is a settlement failure, as well as for fines.
For sovereign debt: In order 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 under which that third party has confirmed that the share has been located or has otherwise reasonable expectation that settlement can be effected when it is due. The restrictions do not apply if the transaction serves to hedge a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the given sovereign debt. In addition, the competent authority may temporarily (for 6 months, renewable) suspend these restrictions where the liquidity of the sovereign debt falls below a pre-determined threshold, to be set by the Commission in a delegated act. ESMA shall develop draft implementing technical standards to determine the types of agreements, arrangements and measures that adequately ensure that the sovereign debt will be available for settlement.
What are the enforcement powers of regulators?
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.
Are any exemptions set out in the Regulation?
Yes, for market making activities, for primary market operations and for shares whose principal market is outside the EU. Market making includes providing price quotes for financial instruments to provide liquidity to the market or to fulfil client orders. Market making activities are exempt because they play an important role in providing liquidity, and restricting their ability to short sell would have a significant adverse effect on the liquidity of markets. Primary market operations are transactions performed by dealers to provide liquidity to issuers of sovereign debt and for the purposes of stabilisation schemes (i.e. share issues intended to stabilise a share price) under the Market Abuse Directive. Primary market operations are legitimate functions that are important for the proper functioning of primary markets. Shares whose principal market is outside the European Union are exempt, because it would not be proportionate to apply short selling requirements where most trading of the share takes place outside the Union.
How and why does the Regulation ban so called "naked" sovereign CDS?
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:
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.
Is the Regulation in line with international principles and the regulatory frameworks of the EU's main international partners?
The International Organisation of Securities Commissions (IOSCO) adopted in June 2009 a 'Final report on regulation of short selling'1 which sets out the following four principles for the regulation of short selling:
The Commission believes that the short selling Regulation is fully compatible with the principles outlined by IOSCO.
The United States has had in place a number of measures in relation to short selling which have been revised several times over the years, notably an uptick rule (which was abolished in 2007). In 2004, the SEC adopted Regulation SHO2 which introduced the following requirements for short selling: a 'locate' rule for short sellers, a flagging regime and a "close-out" requirement for short positions. On 24 February 2010 the SEC adopted the "revised uptick" or "circuit breaker" rule. This rule restricts short sales of a share whose price has fallen by more than 10% compared to its closing price the previous day.
During the financial crisis, the SEC introduced a number of temporary emergency measures restricting short selling. Since 1 August 2009, the SEC has been working with self-regulatory organisations to make short selling volume and transaction data available to the public through the latter's web sites. The Wall Street Reform Act enacted into law by the US President on 21 July 2010 includes certain provisions on short selling, notably it requires the SEC to adopt rules for public disclosure, at least monthly, of the amount of short sales by institutional investment managers.
Regarding CDS and especially sovereign CDS, no specific measures have been adopted by the US authorities for the time being. However, CDS fall within the scope of the Wall Street Reform Act, and the CFTC and SEC will be expected to produce joint rules to implement this.
Hong Kong also has in place measures relating to short selling: a flagging requirement with daily publication of aggregate data on short selling volume, an uptick rule, a locate rule and buy in procedures and fines in case of non-settlement.
The Commission considers that the adoption of the Regulation on short selling and CDS will increase the convergence of the EU's regulatory framework with that of the United States and Hong Kong. A comparison of the EU's proposals with the measures in force in the United States and Hong Kong is included in table 2 below.
What is the timing for final adoption of the Regulation and its entry into force?
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 in the third week of November. 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.
How does this Regulation fit in with other initiatives related to the financial crisis?
In the context of the proposals to revise the Markets in Financial Instruments Directive (MiFID), due on 20 October 2011, the Commission will consider options including transaction reporting, position reporting and the possibility of position limits, which could complement the short selling proposals by providing additional tools to detect and guard against possible systemic risks and risks to market integrity.
In the context of the proposals to revise the Market Abuse Directive, due at the same time as the MiFID, the Commission will consider the option to extend the prohibition of market manipulation to all over the counter instruments, including derivatives, which could impact the prices of financial instruments traded on a regulated market, Multilateral Trading Facility or other organised trading facility. This option would complement the short selling regulation by providing regulators with the tools to sanction possible market manipulation of underlying bond markets through CDS.
Statement by Commissioner Michel Barnier: MEMO/11/712
Comparison of Short Selling Regulation EU – US – Hong Kong – September 2010
For the text of the final report see:
Regulation SHO, Securities and Exchange Commission, 17 CFR PARTS 240, 241 and 242 [Release No. 34-50103; File No. S7-23-03]