Regulatory Corner

Regulatory Corner

European Commission publishes new regulatory proposals on Short Selling and Credit Default Swaps

In the Q2 Edition of Securities Lending Quarterly we reported on the implications of the European Commission’s June consultation paper on possible regulatory measures for short selling and credit default swaps. On September 15 the Commission published its final proposals, together with the results of its consultations with interested parties and impact assessments. The proposals will now have to be approved by the European Parliament and the Council of Ministers before they become law. Once adopted the regulation would apply from 2012.

In its introduction of the proposals the Commission acknowledges that most studies conclude that short selling contributes to the efficiency of markets and increases market liquidity (as the short seller sells securities and then later purchases the identical securities to cover the short sale). Also, by allowing investors to act when they believe a security is overvalued it leads to more efficient pricing of securities, helps to mitigate price bubbles and can act as an early indicator of underlying problems relating to an issuer. It is also an important tool that is used for hedging and other risk management activities and market making.

Key features

The proposal covers all financial instruments but provides for a proportionate response to the risks that short selling of different instruments may represent (e.g., instruments such as shares, sovereign bonds, derivatives relating to shares and sovereign bonds and credit default swaps relating to sovereign issuers where taking short positions is more common). The proposal applies transparency requirements to entities with significant net short positions relating to EU shares, EU sovereign debt and with significant credit default swap positions relating to EU sovereign debt issuers.

The proposal for share transparency is based on the model recommended by the Committee of European Securities Regulators (CESR). For companies that have shares admitted to trading on a trading venue in the Union, it provides for a two tier model for transparency of significant net short positions in shares. At a lower threshold, notification of a position must be made privately to the regulator, and at a higher threshold, positions must be disclosed to the market.

In addition to the transparency regime, the proposal includes a requirement for the marking of short orders. A trading venue will be required to publish daily information about volumes of short sales executed on the venue that is obtained from the marking of orders.

Persons entering into short sales of such instruments must at a time of the sale have borrowed the instruments, entered into an agreement to borrow the shares or made other arrangements which ensure that the security can be borrowed so that settlement can be effected when it is due. The requirement permits legitimate arrangements (such as securities lending programs) that are currently used to enter into covered short selling and which ensure that securities will be available for settlement.

Trading venues must ensure that there are adequate arrangements in place for buy-in of shares or sovereign debt where there is a failure to settle a transaction. In case of non-settlement, daily fines must be imposed. In addition, trading venues will have the power to prohibit a natural or legal person who failed to settle to enter into further short sales.

The proposals are the result of an extensive dialogue and consultation with all the major stakeholders, including securities regulators and market participants. As a member of the International Securities Lending Association, J.P. Morgan contributed to the detailed industry response and will continue to monitor the implications of the proposals and work with other market participants to develop and recommend best practices as the regulations come into force.

U.S.: Dodd-Frank is enacted

On the regulatory front the U.S. Senate voted through the Dodd-Frank Act in July, with President Obama signing it into law later in the month, bringing to a close some of the uncertainty for financial firms (although a lot of the detail still needs to be worked through). Key areas covered by the act include consumer protection, rules around derivatives trading, winding-up of large financial institutions, systematic risk regulation and proprietary trading.

Basel III

The Basel Committee on Banking Supervision softened proposed new capital and liquidity rules leading to a rally in bank shares as another major uncertainty for the sector was removed.

Short Selling

Greece removed its ban on covered short selling effective September 1, leaving the ban in place on naked shorting. Borrowing demand was good, especially in financials.

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