What are the reasons behind the implementation of the short-selling framework in the EU?
There are two distinct parts to the new rules. The section dealing with short-selling rules applying to shares is designed to harmonise the rules that were already adopted by individual EU member states. The section dealing with short selling of sovereign debt is a completely new set of rules that is primarily driven by a view that short selling creates systemic risks and is often abusive and distorts the markets.
Why did EU member states’ national rules on short selling need to be harmonised?
Harmonisation of rules applying to financial markets in the EU has been one of the key drivers for rulemaking coming from EU institutions in number of areas. Coming up with so called a ‘single rulebook’ has been accepted as a way of promoting single EU market and short-selling rules are no different in that respect.
What sort of transparency regime does the short-selling framework implement in Europe?
We need to look separately at the rules to see how they apply to shares and how they apply to sovereign debt. In the context of shares that are listed on one of the EU trading venues, the reporting obligation has two elements to it.
First, anyone who has a net-short position in the shares (irrespective of how such short position is held—whether directly, through options, swaps or otherwise) equal to at least 0.2 percent of the overall issued share capital of the underlying issuer has to send a report to the competent authority regulating the market on which the share is primarily traded. Every time this position is increased or reduced by another 0.1 percent, such an increase / reduction has to be reported as well.
The second prong to the reporting regime on shares is public disclosure. Net-short positions that amount to 0.5 percent or more will be disclosed to the market. With respect to sovereign debt markets, net-short positions in sovereign debt are only reported to the relevant competent authority in the member state that issued the sovereign debt. The reporting thresholds start from 0.1 percent or 0.5 percent, depending on the type of the debt instrument.
What do EU regulators hope to achieve with the transparency regime, and how does it apply to institutions that are not based in the EU?
Regulators are worried that short selling may often amount to market abuse and by requiring market players to disclose short positions, they will be able to better monitor the short-selling activities and take further action if necessary. The regulation obviously has to apply to anyone, including entities that are not based in the EU. Otherwise, it would be very easily avoided and all of the short-selling market would simply move offshore. It remains to be seen, however, how EU regulators will impose the short-selling rules abroad.
How will US-based firms adjust their strategies to accommodate the transparency regime if they want to continue to do short-selling business in the EU?
All firms operating out of US (irrespective of where incorporated) will need to fully comply with the rules. This means, in particular, setting up compliance apparatus that will allow them to first monitor their net-short positions (calculated on a group basis) as of midnight every day and then they will have to establish reporting lines to each of the EU competent authorities to be able to report by 3.30pm (the next day) any net-short positions that reached the reporting threshold.
For a firm that is actively trading in the relevant shares, American depository receipts or taking position in the EU sovereign credit default swap market, this means introducing an automated system that will have to be tailored to reflect the EU rules and provide for calculations of net-short positions, including positions that are held through portfolio swaps, index transactions, futures and some other more complex instruments.
What are the penalties for non-compliance?
Although the rules are being harmonised, the one area that generally remains with local member states authorities is enforcement. It therefore remains to be seen what penalties will be applied to breaches of the short-selling rules. Some member states have already clearly outlined the rules that will apply to enforcement but others have not, so it is too early to conclude what the penalties will be overall.
How likely is it that some market players could abandon it altogether?
This will depend on whether we are talking about short selling in shares or in sovereign debt. The rules on short selling of sovereign debt are new and I can definitely see that number of players in this market will either be prevented from engaging in short selling of sovereign debt going forward or may simply take a view that they won’t build compliance around the complex rules and rather exit the market altogether.
In the context of short selling of shares, these rules do follow regulation that some member states adopted earlier, so the change is significant but more gradual, and I expect that most players will adjust their strategies but will not be exiting the market entirely. Some strategies may well be put on hold though pending the build out of sophisticated reporting systems that would allow the firms to monitor their net-short positions that are held through some of the more complex instruments, such as index trades.
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