Brussels, 29 June 2012
Short selling: technical standards – 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.
The technical standards issued today are designed to ensure that any short selling that takes place on the EU's financial markets is "covered".
What risks does it present?
Concerns have been raised that naked short selling brings with it an increased risk of settlement failure, and that at a time of considerable financial instability, short selling could aggravate falling share prices, notably in financial institutions, in a way which could ultimately threaten their viability and create systemic risks. At the height of the financial crisis in autumn 2008, competent authorities in the United States and several EU Member States adopted exceptional measures to restrict or ban short selling in some or all shares. The measures adopted by Member States were divergent, since the European Union lacked a specific legislative framework for dealing with short selling issues at the time in order to mitigate these risks, while allowing the practice of short selling. The Regulation on Short Selling and Credit Default Swaps1 which entered into force on 25 March 2012 and will apply from 1 November 2012, provides such a framework.
The technical standards that the Commission has adopted today are the practical measures linked to this Regulation.
How is it currently regulated in the EU?
According to Regulation (EU) No 236/2012, short selling of shares can only happen if sellers either have borrowed the shares, have a binding agreement to borrow the shares, or have an arrangement with a third party that means they can reasonably expect to deliver the shares they are selling.
The technical standards adopted today set out the technical details of how this Regulation will apply in practice, notably the types of agreements, arrangements and measures that adequately ensure that the shares sold short are available for settlement. They will apply from 1 November 2012.
What restrictions are provided for in the Short Selling Regulation on naked short selling?
To reduce the risks of settlement failures and increased price volatility that 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 a 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 ensure 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 the 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 a 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 do the technical standards adopted today cover?
The technical standards adopted today lay out in detail:
the different types of agreements, arrangements and measures that adequately ensure that the shares sold short are available for settlement;
the functioning of the "locate rule" for shares and sovereign debt;
the mechanisms of information disclosure, to increase transparency in short selling;
requirements on the types of third parties that can be involved in short selling; and
the method for determining which shares have a principal trading venue outside the EU and are therefore outside the scope of the Short Selling Regulation.
What is the procedure for drafting and adopting these technical standards, and what are the next steps?
The technical standards adopted today have been drafted by ESMA following a consultation of stakeholders and an impact assessment. The drafts were submitted to the Commission by ESMA on 30 March, and the Commission had three months to endorse them. The Commission has adopted the technical standards without changes to the substance. As a result, the Regulatory Technical Standards are subject to a right of objection of the European Parliament and the Council of one month, which can be extended by one month. On expiry of the period of objection, the regulatory technical standards will be published in the Official Journal and will apply from 1 November.
Since the Implementing Technical Standard is an Implementing Regulation of the Commission it is not subject to a right of objection by the European Parliament and the Council; therefore it will enter into force on its publication in the Official Journal and will apply from 1 November.
What are the different kinds of agreements that adequately ensure settlement for short selling of shares and sovereign debt?
The types of agreements are:
futures and swaps;
standing agreements or rolling facilities;
agreements relating to subscription rights; and
other claims or agreements that lead to the delivery of shares or sovereign debt for the purposes of short selling.
All these types of agreements must cover at least the number of shares or the amount of sovereign debt being sold short, must be entered into prior to or at the same time as the short sale and must specify a delivery or expiration date that ensures settlement of the short sale can be effected when due. These agreements must exist in a "durable medium", whether in electronic or paper form, and are legally binding for the duration of the short sale.
What is the "locate rule" and what does it involve for shares?
The "locate rule" is a term used to describe the arrangement whereby a broker confirms to a short seller that they have located the shares which the short seller needs to borrow to cover their short sale, taking into account the amount required and market conditions. It is thanks to this arrangement and the subsequent measures to be taken vis-à-vis third parties that the short seller is able to have the reasonable expectation that he can deliver the shares he is short selling. The locate rule is an essential part of EU law on short selling: without location of the shares to be sold short, and the subsequent measures vis-à-vis third parties, short selling of shares is not permissible.
There are three different ways that the locate rule can work which are detailed in the technical standards:
The broker confirms he has located the shares to be sold, and he at least puts them on hold. This is the standard functioning of the locate rule.
In the case of short selling that is to take place within the same day, known as intraday short-selling, the short seller needs first to inform the broker that this is his intention. The broker then confirms he has located the shares to be sold. The broker then has to either confirm that the share is easy to borrow or purchase, or if not that he has at least put the required amount of shares on hold. The short seller must monitor the market, and if he finds he risks not being able to deliver, he must then give an instruction to the broker to buy the shares needed to cover his short sale.
In the case of liquid shares, the broker confirms he has located the shares to be sold, and that either the shares are easy to borrow or purchase in the required amount, or that he has at least put them on hold. The short seller gives the broker a commitment that he will give him an instruction to buy or borrow the shares needed to cover his short sale if it transpires that he is not able to buy them in the market.
All of these variants of the locate rule build on existing market practice and on the regulatory framework in the United States.
The broker, or third party used to locate shares, must be a legally separate entity from the seller. It cannot for example be the internal lending desk of the same investment firm. The technical standards also set out the types of third party that can provide locate confirmations, and the requirements they have to fulfil. These are: participating in the management of borrowing or purchasing of the shares or sovereign debt; providing evidence of such participation; and being able to provide on request evidence of their ability to deliver, including statistical evidence.
What are the rules on uncovered short selling of sovereign debt?
The requirements for uncovered short selling of sovereign debt in the Short Selling Regulation are different than those for shares, to reflect the specificities of the sovereign debt markets. The key difference is that unlike for shares, for sovereign debt there is no requirement on the third party to put the sovereign debt on hold. According to the technical standards, for short sales of sovereign debt there are four different kinds of arrangements that make short selling permissible:
A third party (broker) must confirm that the sovereign debt has been located, that is to say that it considers that it can make the sovereign debt available for settlement in due time;
In the case of intra-day short selling of sovereign debt, the short seller has to confirm to the broker that this is his intention; the third party (broker) then confirms to the short seller that it has a reasonable expectation that the sovereign debt can be purchased in the relevant quantity, taking into account the market conditions and other information available to it.
The short seller goes through a third party which participates in a structured arrangement, such as one organised by a central bank, that gives it unconditional access to the sovereign debt to be sold short in the amount required for settlement, and can therefore confirm that it has a reasonable expectation that settlement will take place when due.
A third party (broker) confirms that the sovereign debt being sold short is easy to purchase in the relevant quantity taking into account market conditions.
How will these measures for sovereign debt affect the management of countries' budget deficits?
The restrictions on uncovered short selling of sovereign debt are lighter than those required for shares. This is because they have been tailored for sovereign debt. Therefore, these new technical standards should not affect the management of countries' budget deficits.
Furthermore, a safeguard is in place in the Short Selling Regulation: if a country finds that its sovereign debt market is being impaired by these restrictions – if there is a significant decline in the liquidity of the sovereign debt – then it can suspend these standards for six months, as long as liquidity has fallen below a threshold set by the Commission in a delegated act. This delegated act is due to be adopted shortly by the Commission as required by the Short Selling Regulation.
What are the detailed technical rules on information disclosure?
In order to improve transparency of short selling, the Short Selling Regulation requires information on significant short sales of shares and sovereign debt to be notified to the regulator, once a reporting threshold has been crossed. For shares, the threshold represents a short position of 0.2% or more of that company's share capital. For sovereign debt, the thresholds are to be set by the Commission in the delegated act to be adopted shortly. For shares only, if the short position represents 0.5% or more of the issued share capital, information on the sale needs to be disclosed to the public.
The technical standards adopted today require that information on significant short positions in shares disclosed to the public must be disclosed on a central web site operated or supervised by the regulator, in a machine-readable format so that the public can search the web site for information by issuer and access historical data.
Will these measures apply to dual traded shares that are traded both inside and outside the EU?
In the case of shares traded both within and outside the EU, the Short Selling Regulation requires ESMA to determine the shares' principal trading venue, and this will determine whether the shares are subject to the Short Selling Regulation; if the principal trading venue is outside the EU, these measures will not apply. ESMA is also required to regularly publish a list of exempted dual-traded shares.
The technical standards adopted today set out the process for ESMA to determine what the principal trading venue for dual-listed shares is.