Short selling and credit default swaps regulation

Reference text

European regulation 2010/0251 (COD)

Entry into force

1^st November 2012

What is the Short selling and credit default swaps regulation?

This regulation stems from two events that marked the financial world: the financial crisis in 2008, followed by the strong movements on sovereign debts. The financial crisis which followed the collapse of Lehman Brothers obliged regulators, more or less everywhere in the world, to take measures aiming to restrict short selling. These initial measures were taken as a matter of urgency without any real global coordination or coherence.

The objective of this regulation is to construct a preventative framework (comprising permanent measures, alongside temporary measures that can be activated by the competent authorities in exceptional situations), that is reasoned (the project does not undermine the benefits that short selling can entail under normal market conditions and exempts certain activities) and harmonised, aiming to govern short selling of shares and sovereign debts and the use of CDSs on sovereign debts. Such a framework is only fully effective of course if it is accompanied by a reinforcement of the powers granted to the local competent authorities and the ESMA, and an increase in the transparency necessary to exercise their function. The text thus specifies the role of the various competent authorities and stresses the need for cooperation among them.

Mainly targeted at investors (corporate entities and private individuals), the text covers short selling according to two themes:

• an obligation for declaration to the authorities (possibly accompanied by a public version),
• the obligation to have taken all necessary measures to enable settlement of the sale on the intended date. Concerning CDSs, it prohibits them from negotiating “naked”, i.e. without having a long position to hedge over the debt itself.

It should be noted that the text also imposes on Clearing Houses the establishment of penalties for late settlement and a harmonised buy-in procedure (activated 4 trading days after the intended settlement date) in line with what seems set out in the proposed regulation on central securities depositories. It is furthermore not the only case of connection between the proposed texts of the EC: the marking of short selling orders, once envisaged in this regulation, has been finally abandoned to the benefit of marking of transactions through the Transaction Reporting as set out in the future MiFIR. However as the Transaction Reporting is to be done by the entity executing the order, it is no more than a marking of orders since the seller will have to flag the order when sending it for execution. The only difference is that only executed orders will be declared.

The main points of the Short selling and credit default swaps Regulation

• Scope: In order to provide for a preventive regulatory framework to be used in exceptional circumstances, the Regulation covers all types of financial instruments but provides for a response proportionate to the potential risks posed by the short selling of different instruments. It is only in the case of exceptional circumstances that competent authorities and ESMA are entitled to take measures concerning all types of financial instruments, going beyond the permanent measures that only apply to particular types of instruments where there are clearly identified risks that need to be addressed.

• Transparency of significant net short positions: for shares admitted to trading on a trading venue in the Union, a two-tier model is introduced, that provides for greater transparency of significant net short positions in shares at the appropriate level: (i) at the lower threshold, notification of a position should be made privately to the regulators concerned; (ii) at the higher threshold, positions should be publicly disclosed to the market. A relevant publication threshold is a percentage that equals 0.5 % of the issued share capital of the company concerned and each 0.1 % above that. A requirement to notify regulators of significant net short positions relating to sovereign debt in the Union should be introduced as such notification would provide important information to assist regulators in monitoring whether such positions are in fact creating systemic risks or being used for abusive purposes. Such a requirement should only include private disclosure to regulators as publication of information to the market for such instruments could have a detrimental effect on sovereign debt markets where liquidity is already impaired. For sovereign debt, on the other hand, significant net short positions relating to issuers in the EU will always require private disclosure to regulators. The proposed regime also provides for notification of significant positions in credit default swaps that relate to EU sovereign debt issuers. Natural and legal persons that hold significant net short positions shall keep, for a period of 5 years, records of the gross positions which make a significant net short position. The text states that the relevant time for calculation of a net short position shall be at midnight at the end of the trading day on which the natural or legal person holds the relevant position. The notification of information to a relevant competent authority shall ensure the confidentiality of the information and incorporate mechanisms for authenticating the source of the notification.

• Restrictions on uncovered short selling in shares: to reduce the risks of uncovered short selling of shares, the Regulation provides that a natural or legal person may enter into a short sale of a share admitted to trading on a trading venue only where that person has: (i) borrowed the share or has made alternative provisions resulting in a similar legal effect; or (ii) entered into an agreement to borrow the share or has another absolutely enforceable claim under contract or property law to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due or (iii) 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 natural or legal person to have a reasonable expectation that settlement can be effected when it is due.However, these restrictions don't apply to the short selling of sovereign debt if the transaction serves to hedge a long position in debt instruments of an issuer. Moreover, if the liquidity of sovereign debt falls below a specified threshold, the restrictions on uncovered short selling may be temporarily suspended by the competent authority. 

• Exceptional situations: in exceptional situations that threaten financial stability or market confidence in a Member State or the EU, the Regulation provides that competent authorities should have temporary powers to require greater transparency or to impose restrictions on short selling and credit default swap transactions or to limit individuals from entering into derivative transactions. In such a situation, the European Securities Market Authority (ESMA) is given a key coordination role, to ensure consistency between competent authorities and to guarantee that such measures are only taken where they are necessary and proportionate. ESMA is also given the power to take measures where the situation has cross-border implications

• ESMA inquiries: ESMA may, on the request of one or more competent authorities, the European Parliament, the Council or the Commission or on its own initiative conduct an inquiry into a particular issue or practice relating to short selling or relating to the use of credit default swaps to assess whether that issue or practice poses any potential threat to financial stability or market confidence in the Union.

• Cooperation with third countries: the competent authorities of Member States shall wherever possible conclude cooperation arrangements with competent authorities of third countries concerning the exchange of information with competent authorities in third countries, the enforcement of obligations arising under the Regulation in third countries and the taking of similar measures in third countries by their competent authorities.

• Penalties: the measures, sanctions and penalties provided for shall be effective, proportionate and dissuasive. In accordance with Regulation (EU) No 1095/2010, ESMA may adopt guidelines to ensure a consistent approach is taken concerning the measures, sanctions and penalties to be established by Members States. ESMA shall publish on its website and update regularly a list of existing administrative measures, sanctions and penalties per Member State.