Many industry participants are up in arms over proposed new European Union rules to limit short selling and the trading of certain aspects of credit default swaps where there is a threat to financial stability.
Given just three weeks to respond to a consultation paper produced by the EU’s financial markets regulator, the European Securities and Markets Authority, in mid-February on the matter, almost all respondents were worried about the lack of time given to evaluate the meaty proposals and the problems that the regulation itself is likely to cause in its present format. The Council of Ministers, European parliament and the Commission all agreed details of the legislation last October.
“We appreciate the need for swift implementation of the regulation; however, the highly technical nature of the issues involved and the importance of the regulation’s adequate implementation require thorough assessment which is not possible in the short time given,” said Stefan Gavell, executive vice-president, global head of regulatory, industry and government affairs at custodian bank State Street.
“This lack of an in-depth impact assessment of the suggested implementing measures risks leading to unintended consequences for financial services and their users.”
ESMA has been in consultation with stakeholders over implementation of these rules and the independent EU body expects a final report and submission of the draft to the European Commission by mid-April with regulations due to enter into force in November, which will then be binding across all EU member states.
But many in the industry are fearful of the proposals, especially plans to limit short selling.
“It is widely recognized that short selling facilitates efficient price discovery, mitigates price bubbles, increases market liquidity and provides solutions for effective hedging and other risk management strategies,” said asset manager BlackRock in its response to ESMA’s consultation paper. “These benefits allow investment managers to achieve, for long-term savers, optimal investment performance, cost efficiency and stable risk profiling of products.”
Transparency rules in the regulation state that for significant net short positions in shares of EU listed companies, the regulation will create a two-tier reporting model where at a lower threshold positions must be published privately to regulators so the latter can investigate short sales that may constitute market abuse or systemic risk. At a higher threshold, positions must be disclosed to the market in order to provide useful information to other participants. For sovereign debt, significant net short positions relating to issuers in the EU will always require private disclosure to regulators.
BlackRock added that the publication of these positions could lead to the “risk of herding” where the publication of the positions of those seen as ‘star’ managers will inevitably lead others to following suit. It also alluded to “the possibility of short squeezes”, allowing other market participants to move against large short positions, and “market distortion” whereby managers would always limit their net short position to remain under the threshold.
To tackle the increased risks posed by uncovered short sales, the proposal requires that anyone entering into a short sale must at the time of the sale have borrowed the instruments or entered into an agreement to borrow them or made other arrangements to ensure they can be borrowed in time to settle the deal. The new rules will also give national regulators new powers, and under certain circumstances ESMA will be able to ban short selling.
However, the London Metal Exchange, a futures and options venue, went even further in its stance against the plans.
“The basic point is that on a commodity futures market naked short selling for future dates is the natural hedging strategy for a commodity producer,” said Diarmuid O’Hegarty, deputy chief executive of LME.
“Closing the market to short sellers removes the ability of producers to hedge and removes the liquidity for long buyers. We believe that a short selling ban would itself cause such market disorder that we would have to close the whole market during the ban. There is no evidence that uncovered short sales on commodity derivatives markets are detrimental to those markets.”
In addition, the rules allow regulators to temporarily suspend sovereign credit default swap positions when they deem stability is at risk. The rules will prohibit naked sovereign credit default bets when they aren't used to hedge an exposure, but member states will be able to shelve these restrictions under certain circumstances. Traders also will be obliged to meet new reporting requirements on significant short positions.
“For example, on the issue of correlation in respect of sovereign CDS and, especially, the ability to cross-border hedge, ESMA appears to go beyond what the text quite unambiguously states,” said the Alternative Investment Management Association in its filing to ESMA. “In doing so, ESMA has proposed a more restrictive regime than was intended or than is necessary. We would urge ESMA to reconsider its advice.”
In August last year, France, Spain, Italy and Belgium banned short selling bank and insurance stocks to stabilize the market but this current fragmented approach has limited its effectiveness and created regulatory arbitrage. The new regulation is aimed at addressing this but, at the same time, acknowledging the role of short selling in ensuring the proper functioning of financial markets, in particular in providing liquidity and contributing to efficient pricing.