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Brussels, 5 July 2012
Commission Delegated 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, although the seller will subsequently need to buy the security in order to be able to deliver the security to the buyer. 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.
What is a Credit Default Swap?
A sovereign Credit Default Swap (CDS) is a derivative in which the seller of the CDS agrees to compensate the buyer in the event of a default of the referenced sovereign in return for an annual premium. It can be regarded as a form of insurance against the credit risk of the default of a sovereign.
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"), the investor will gain from, rising credit risk or the default of the bond issuer. This is economically equivalent to short selling the underlying bond.
Why has the Commission adopted a Delegated Regulation on short selling and CDS, and how does this relate to the Short Selling Regulation?
The Commission is empowered by the Short Selling Regulation1 to adopt delegated acts by 31 March 2012 (which can be extended by 6 months) specifying certain technical elements of the Regulation, to ensure its consistent application and to facilitate its enforcement. The technical issues to be addressed in these delegated acts are set out in the Regulation and are explained further below.
What is the procedure for adopting this Delegated Regulation?
The Delegated Regulation is a delegated act of the European Commission. This is an autonomous act of the Commission which is drafted and adopted by the Commission. While the Commission has requested and taken into account the technical advice of the European Securities and Markets Authority (ESMA) on the technical issues covered by this delegated act, the Commission is not bound in any way by this advice. Prior to issuing its final technical advice, ESMA consulted stakeholders on draft technical advice. The Commission has also prepared an impact assessment accompanying the Delegated Regulation which considers the impacts of the different options, as well as the technical advice of ESMA and the views of stakeholders. In its preparatory work the Commission has also consulted the expert group of the European Securities Committee, the European Parliament, and the European Central Bank. Following adoption by the Commission, this Delegated Regulation is subject to a three month objection period during which either the European Parliament or the Council can object to the Delegated Regulation; this period can be extended by a further three months. If neither of the co-legislators objects during this period, the Delegated Regulation is published in the Official Journal and enters into force. Provided that the co-legislators do not exercise their right to object, the Delegated Regulation is therefore expected to be published in the Official Journal by mid-October and to enter into force on 1 November 2012, the date of application of the Short Selling Regulation.
What are the objectives of the delegated regulation?
The objectives of the Short Selling Regulation are to:
increase the transparency of short positions held by investors in certain EU securities;
ensure Member States have clear powers to intervene in exceptional situations to reduce risks to financial stability and market confidence arising from short selling and credit default swaps,
ensure co-ordination between Member States and the European Securities and Markets Authority (ESMA) in adverse situations;
reduce settlement and other risks linked with uncovered or naked short selling; and
reduce risks to the stability of sovereign debt markets posed by uncovered ("naked") CDS positions, while providing for the temporary suspension of restrictions where sovereign debt markets are not functioning properly.
The Delegated Regulation specifies certain technical elements of the Short Selling Regulation in order to ensure consistent compliance by market participants and enforcement by competent authorities. The objectives of the Delegated Regulation are to ensure that:
regulators apply the restrictions on uncovered short sales of sovereign debt and the ban on uncovered sovereign CDS positions in a clear and consistent way;
regulators have clear and consistent powers to temporarily restrict short selling in the event of a significant price fall;
regulators and markets obtain useable data on short positions in sovereign debt; and
ensure a coordinated regulatory response by EU Member States to short selling and sovereign CDS.
What are the key issues addressed by the Delegated Regulation?
The delegated regulation specifies:
certain key terms in the Short Selling Regulation, such as what it means to "own" or "hold" a share for the purposes of the Regulation, are further specified;
the technical details of how to calculate significant short positions in shares or sovereign debt, which are to be notified to the regulator or disclosed to the public;
how net short positions are to be calculated and reported by funds managing several funds and by different entities within a group company, in order to avoid circumvention of the transparency rules in the Short Selling Regulation;
the details of the cases in which a sovereign CDS is considered to be legitimate hedging and therefore deemed "covered" for the purposes of the ban on uncovered sovereign CDS;
the thresholds at which significant short positions in the sovereign debt of Member States and other sovereign and EU issuers (the German Länder, the European Financial Stability Facility (EFSF), the European Stability Mechanism (ESM) and the European Investment Bank (EIB) have to be notified to regulators;
the threshold for the significant decline in the liquidity of a sovereign debt market which allows a regulator to temporarily suspend restrictions on short selling of sovereign debt;
the thresholds for significant price falls for financial instruments other than liquid shares that can trigger a short term suspension of short selling by national regulators; and
the meaning of adverse events, threats, and developments that can trigger temporary restrictions on short selling by national regulators and, in cross-border exceptional situations, by ESMA.
In what cases will a buyer of sovereign CDS be deemed covered and therefore not subject to the ban on uncovered sovereign CDS?
The Short Selling Regulation prohibits persons from entering into uncovered sovereign CDS transactions, but covered sovereign CDS may still be legitimately taken out to hedge exposures to certain assets or liabilities. The Commission has specified in the delegated Regulation which cases constitute covered sovereign CDS.
The Delegated Regulation therefore specifies in some detail the cases which constitute a legitimate covered sovereign CDS. Firstly, the hedged assets and liabilities must be of a certain defined types. Secondly, the exposure should not exceed the value of the hedging CDS when it is entered into. Thirdly, the assets and liabilities must at least be meaningfully correlated with the sovereign CDS, and this correlation must be demonstrated through either a quantitative or a qualitative test (see below). Finally, although cross border hedging – using the CDS referencing one Member State to hedge against exposures in another Member State - is not permitted by the Short Selling Regulation, certain tight and specific provisions are specified in the Delegated Regulation governing the hedging of multinational exposures.
How will a sovereign CDS position holder have to demonstrate correlation?
The holder of a covered sovereign CDS can demonstrate correlation between the hedged assets and liabilities and the sovereign CDS by meeting either of the two correlation tests set out in the Delegated Regulation. Firstly, under the "quantitative" test, when a correlation co-efficient of at least 70% is shown based on certain specified data and methods, then the correlation test will be met. Secondly, the "qualitative" test is that there should be a meaningful correlation between the hedged exposure and the sovereign CDS. This calculation should be based on appropriate data and not show evidence of a merely temporary dependence. Finally, certain hedged exposures may be deemed to meet the correlation test per se – for example, hedging regional government exposures using the sovereign CDS of the relevant state will be automatically deemed to meet the correlation test, without the need to perform either the qualitative or quantitative tests. The holder will need to demonstrate to their supervisors how the test was met if required.
How does the Delegated Regulation promote transparency in short selling of shares?
The Short Selling Regulation requires significant short positions in shares to be notified to regulators at one threshold (0.1% of issued share capital), and disclosed to the public at a higher threshold (0.5%). The Delegated Regulation sets out the technical details of how to calculate those net short positions, including how net short positions should be calculated by different funds managed by the same fund manager, or by different entities within a group company.
How does the Delegated Regulation promote transparency in short selling of sovereign debt?
The Short Selling Regulation requires significant short positions in sovereign debt to be notified to national regulators, but does not set the thresholds for such reporting, leaving these to be specified in a delegated act. The Delegated Regulation therefore sets out the notification thresholds for significant short positions in sovereign issuers. In light of the technical advice of ESMA, the Delegated Regulation proposes two categories of thresholds: a threshold of 0.1% of issued sovereign debt where the total amount of the outstanding issued sovereign debt is between 0 and 500 billion euro; and a threshold of 0.5% where the total amount of the outstanding issued sovereign debt is above 500 billion euro or where there is a liquid futures market for the particular sovereign debt. The additional notification thresholds above those initial levels will be 0.05% (starting at 0.15%) and 0.25% (starting at 0.75%) respectively. Each issuer of sovereign debt in the EU will therefore fall into one or the other reporting category. It should be noted that sovereign issuers as defined in the Short Selling Regulation include the German Länder and EU issuers such as the European Financial Stability Facility (EFSF), the European Stability Mechanism (ESM) and the European Investment Bank (EIB) as well as the 27 EU Member States.
The Delegated Regulation also details how net short positions in sovereign debt are to be calculated, including where there is a long position in sovereign debt of another sovereign issuer which is highly correlated with a given sovereign debt. The Delegated Regulation specifies that a high correlation means a correlation of 80%.
In what circumstances can Member States suspend the restrictions on uncovered short selling of sovereign debt?
The Short Selling Regulation sets out certain restrictions on uncovered short sales of sovereign debt, in order to reduce the risks of settlement failure. To enter a short sale, an investor must have borrowed the sovereign debt, entered into an agreement to borrow it, or have an arrangement with a third party under which that third party has confirmed that the sovereign debt 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. The Delegated Regulation specifies that "high correlation" means a correlation of 80%.
In addition, Short Selling Regulation empowers competent authorities to 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. This Delegated Regulation therefore sets the threshold for the significant decline in liquidity necessary for this temporary suspension power to be triggered. The Delegated Regulation specifies that such a temporary suspension may be triggered when the turnover in the sovereign debt concerned in a given month falls below the fifth percentile of the monthly volume traded in the previous twelve months. Before exercising the power, regulators are required to check that this significant drop in liquidity is not due to seasonal effects on liquidity (i.e. declines in liquidity usually observed in August or December).
What are the thresholds which may trigger a short term suspension of short selling of illiquid shares and other financial instruments?
The Short Selling Regulation gives national regulators 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 regulator may extend the measure for up to a further two trading days. The Short Selling Regulation sets a threshold of 10% for liquid shares, but leaves it to a delegated act to specify the thresholds for illiquid shares and for other financial instruments.
The Delegated Regulation specifies the following thresholds for significant price falls in the following financial instruments during a single trading day:
where a share is included in the main national equity index and is the underlying financial instrument for a derivative contract admitted to trading on a trading venue (semi-liquid shares), a decrease in the price of the share of 10% or more;
where the share price is EUR 0.50 or higher, or the equivalent in the local currency, (illiquid shares) a decrease in the price of the share of 20% or more;
for all other (very illiquid) shares: a decrease in the price of the share of 40% or more;
for sovereign bonds: an increase of 7% or more in the yield across the yield curve during a single trading day for the relevant sovereign issuer;
for corporate bonds: an increase of 10% or more in the yield of a corporate bond during a single trading day;
for money market instruments: a decrease of 1.5% or more in the price;
for exchange traded funds, including those which are Undertakings for Collective Investments in Transferable Securities (UCITS): a decrease of 10% or more in the price;
for derivatives which have as a sole underlying a financial instrument traded on a trading venue and for which a significant fall in value is specified in this Delegated Regulation: a significant fall in value in that derivative instrument shall be considered to have occurred when there has been a significant fall in that underlying financial instrument.
No threshold for a significant fall in the value of the unit price of a listed UCITS, except for Exchange Traded Funds that are UCITS, is specified in this Delegated Regulation, as although the price may vary freely in the trading venue, it is subject to a rule in Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) which keeps the prices close to the Net Asset Value of the UCITS.
No threshold for a significant fall in the value of derivatives which have an underlying which is not a financial instrument, including commodity derivatives, is specified in this Regulation. Given the diversity of these other derivatives, the difficulty of calculating consistent and stable thresholds and the potential to circumvent any threshold, the Commission considered that it is not proportionate or effective to set a threshold for these other derivatives. Article 45 of the Short Selling Regulation requires the Commission to make a report to the European Parliament and the Council on various aspects of the application of this regulation. The Commission may therefore adopt a delegated act in relation the thresholds for UCITS and other derivatives, in particular commodity derivatives, after this review.
What criteria should national regulators or ESMA take into account in determining whether there are adverse events or developments which could trigger a temporary ban on short selling?
The Short Selling Regulation provides that in exceptional situations, national regulators will have powers to impose temporary measures for up to three months (renewable), such as to require further transparency or to restrict short selling and credit default swap transactions. ESMA is given a central role in coordinating action in exceptional situations and ensuring that powers are only exercised where necessary. ESMA can also act itself when the threat from adverse events or developments has a cross-border dimension and action by national regulators is insufficient to address the threat, or in the case of sovereign debt where an emergency is declared by the Council. 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.
This Delegated Regulation therefore specifies what are the criteria or factors to be taken into account by national regulators when determining whether there is a threat to financial stability which could trigger temporary short selling bans. These include, for example, serious financial, monetary or budgetary problems or other matters which may lead to financial instability concerning a Member State or a bank and other financial institutions deemed important to the global financial system. Another example is damage to the physical structures of important financial issuers, market infrastructures, clearing and settlement systems, and supervisors which may adversely affect markets in particular where such damage results from a natural disaster or terrorist attack.