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Proposal for a Regulation on Short Selling and Credit Default Swaps - guide

15 September 2010
by eub2 -- last modified 15 September 2010

The European Commission has adopted a proposal for a regulation on short selling and certain aspects of Credit Default Swaps (CDS). Its main objectives are to create a harmonised framework for coordinated action at European level, increase transparency and reduce risks. The new framework will mean regulators – national and European - have clear powers to act when necessary, whilst preventing market fragmentation and ensuring the smooth functioning of the internal market.


What is short selling?

Short selling is the sale of a security that the seller does not own, with the intention of buying back an identical security at a later point in time in order to be able to deliver the security. 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.

Who engages in short selling and why?

Short selling is used by a variety of market participants including hedge funds, traditional fund managers such as pension funds and insurance companies, investment banks, market makers and individual investors. Short selling can be used for the following reasons:

* for speculative purposes (e.g. to profit from the expected decline of a share price);
* to hedge a long position (e.g. to limit losses in comparable shares in which a long position is held);
* for arbitrage (e.g. to profit from the difference in price between two different but inter-related shares); and
* for market making (e.g. to meet customer demand for shares which are not immediately available).

What is the volume of short selling?

It is difficult to obtain reliable data on the extent of short selling of shares in Europe in the absence of marking of transactions, or of disclosure of short selling transactions. Most regulators consulted by the Commission were unable to provide reliable data on the volume of short selling transactions in their jurisdictions. However, the level of securities lending can be used as a proxy and according to this data, short selling in Europe could be estimated to represent between 1 and 3% of market capitalisation. Using the data on disclosures of net short positions available from some Member States (e.g. UK and Spain) it could be estimated to be less than 1% of the total share capital of the issuer. According to data obtained from Greece, which has a system of flagging in place, the volume of short selling is in a range of 0 to 3.33% of the total volume of shares traded.

What is a Credit Default Swap?

A Credit Default Swap (CDS) is a derivative which is sometimes regarded as a form of insurance against the risk of credit default of a corporate or government (or sovereign) bond. In return for an annual premium, the buyer of a CDS is protected against the risk of default of the reference entity (stated in the contract) by the seller. If the reference entity defaults, the protection seller compensates the buyer for the cost of default.

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"), he is expecting, and potentially gaining from, rising credit risk. This is equivalent to short selling the underlying bond.

Who trades in CDS and why?

There are four main groups of market participants in the CDS market: dealers, non-dealer banks, hedge funds and asset managers. The dealers are by far the largest players on the market. The aims of these market participants are diverse and they employ different strategies.

CDS can be used for the following purposes:

* hedging: CDS can be used to neutralise or reduce a risk to which the CDS buyer is exposed from another position. An example of such an "insurable interest" would be a bondholder's exposure to the credit risk of the issuer of the bond; by buying a CDS he can reduce that risk by passing it on to the CDS seller;
* arbitrage: The typical arbitrage operation that involves CDS is the combination of buying a CDS and entering into an asset swap where the fixed coupon payments of a bond are swapped against a stream of variable payments; or
* speculation: CDS can also be used to take a position in order to exploit price changes by trading in and out. For example, a CDS seller has taken on risk (in exchange for the regular payments he receives from the CDS buyer); he will gain from the contract if the credit risk does not materialise during the contract's term or if the compensation received will exceed a potential payout.

What is the volume of CDS transactions?

At the end of May 2010, the gross notional amount of the total CDS market was estimated at USD 14.5 trillion, with about 2.1 million contracts outstanding. The sovereign CDS market, which includes both sovereign indices and sovereign single names, reached USD 2.2 trillion, with about 0.2 million contracts outstanding. The outstanding gross notional amount of the Itraxx Sovereign Index Western Europe was USD 140 billion (and USD 10 billion in net terms).

Why is the Commission proposing legislation on short selling and CDS?

During the financial crisis and more recently in the context of market volatility in euro denominated sovereign bonds, Member States have reacted differently to the issues raised by short selling and credit default swaps (see table 1). A variety of measures have been adopted using different powers by some Member States while others have not taken action. There is currently no legislative framework at European level to deal with these issues in a coherent way. A fragmented approach to these issues can limit the effectiveness of the measures imposed, lead to regulatory arbitrage (which basically means shopping around for the least onerous regime) and create additional costs and difficulties for investors.

While the Commission acknowledges that short selling has economic benefits and contributes to the efficiency of EU markets, notably in terms of increasing market liquidity, more efficient price discovery and helping to mitigate overpricing of securities, it also presents risks.

While reducing the scope for regulatory arbitrage and compliance costs arising from a fragmented regulatory framework, the three main risks of short selling which the Commission is seeking to address in these proposals are:

* transparency deficiencies: the current lack of transparency in relation to short selling prevents regulators from being able to detect at an early stage the development of short positions which may cause risks to financial stability or market integrity. Greater transparency to the market on short selling would deter aggressive short selling and give useful information to the market about how short sellers view the performance and prospects of companies.
* the risk of negative price spirals: many regulators have expressed concerns about the risks of short selling amplifying price falls in distressed markets, and that this could lead to systemic risks. It was due to these concerns that a number of Member States introduced emergency measures to restrict or ban short selling in some or all shares in autumn 2008. Concerns have also been expressed by some Member States that short positions through CDS transactions could in some circumstances contribute to a decline of sovereign bond prices.
* the risks of settlement failure associated with naked short selling: when a short seller sells a financial instrument short without first borrowing the instrument, entering into an agreement to borrow it, or locating the instrument so that it is reserved for borrowing prior to settlement ("naked short selling"), there is a risk of settlement failure. Some regulators consider that this could endanger the stability of the financial system, as in principle a naked short seller can sell an unlimited number of shares in a very short space of time.

Today's proposal addresses both short selling and CDS because CDS can be used to secure a position economically equivalent to a short position in the underlying bonds. The buyer of a naked CDS benefits from the deterioration of the credit risk of the issuer in a very similar manner to the benefit which the seller of the bonds derives from this same deterioration which decreases the prices of the bonds.

What preparatory work has been undertaken prior to this proposal, and what related work is ongoing?

In the context of its ongoing review of the Market Abuse Directive, the Commission asked some high level questions in April 2009 (IP/09/600) about the possibility of a new European short selling regime. The responses gave some support for a new regime.

Also in 2008 the Commission asked the European Securities Markets Expert group (ESME), an advisory group comprised of market participants to prepare a report on short selling. The report containing a series of recommendations was adopted in March 2009. (1)

In March 2010, the Committee of European Securities Regulators (CESR) published a report recommending a pan-European model for the disclosure of short positions in EU shares. CESR recommended that short positions should be disclosed to regulators at one threshold and to the market at a higher threshold (see section on transparency below).

More recently, in the Commission Communication of 2 June 2010 on Regulating Financial Services for Sustainable Growth the Commission indicated that it would propose appropriate measures relating to short selling and credit default swaps.(2) This Communication also highlights other initiatives, such as legislation on market infrastructure (due to be adopted mid-September 2010), the review of the Markets in Financial Instruments Directive (due early 2011) and the review of the Market Abuse Directive (due end 2010/early 2011), which will also affect the regulatory framework applicable to derivatives and credit default swaps. By Easter 2011, the Commission will have proposed a comprehensive framework for these issues.

In March 2010 the Commission services established an internal taskforce to examine concerns expressed by some Member States that sovereign CDS were causing excessive volatility on the underlying sovereign bond markets. The findings of the taskforce underpin the impact assessment accompanying the proposal (the report remains confidential as it is not final and includes confidential data).

The Commission consulted in June of this year seeking views of market participants, regulators and other stakeholders about possible measures relating to short selling and credit default swap issues that could be included in a legislative proposal. The responses to the public consultation can be viewed here.

Prior to the adoption of this proposal by the College, the Commission services carried out an impact assessment which has been published alongside the proposal. The impact assessment took into account the responses to the public consultation, as well as questionnaires to regulators and market participants, and an analysis of published studies. It compared the different policy options in terms of their effectiveness and efficiency in meeting the objectives of the proposal. An executive summary of the impact assessment is also available.

What are the objectives of the proposal?

The objectives of the proposal are to:

* increase transparency on short positions held by investors in certain EU securities;
* ensure Member States have clear powers to intervene in exceptional situations to reduce systemic risks and 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 Markets Authority (ESMA) in exceptional situations; and
* reduce settlement risks and other risks linked with uncovered or naked short selling.

How does the proposal enhance the transparency of short selling?

Transparency is key in ensuring the efficient functioning and monitoring of financial markets. So, several measures to enhance transparency in short selling are proposed for shares and government debt.

- for shares:

For EU shares the proposals to enhance transparency are largely based on the two tier model recommended by CESR (the Committee of European Securities Regulators) in its report in March 2010. At a lower threshold (0.2% of the issued share capital) notification of a short position would be made only to the regulator and at a higher threshold (0.5%) short positions would be disclosed to the market. Notification to regulators would enable them to monitor and, if necessary, investigate short selling that may pose systemic risks or be abusive. Publication of information to the market would provide useful information to other market users and act as a disincentive to aggressive short selling strategies.

The disclosure regime for shares is complemented by a system of flagging: all share orders on trading venues would be marked as 'short' by persons executing orders if they involve a short sale, so that regulators can obtain additional information about short selling volumes. The trading venue would publish daily a summary of the volume of orders marked as short orders.

- for sovereign bonds:

A specific regime for notification to regulators only of significant net short positions in EU sovereign bonds is proposed. This would also include notification of significant credit default swap positions relating to sovereign debt issuers. Disclosure to regulators of significant net short positions relating to EU sovereign bonds could provide important information to assist regulators to monitor whether such positions are creating disorderly markets or systemic risks or are being used for abusive purposes. The proposals on sovereign bonds provides for information to be disclosed only to regulators rather than to the market as public disclosure could have negative consequences for the operation of sovereign bond markets, notably in terms of liquidity. The evidence from the short selling disclosure regimes for shares at national level is that these have not had an undue impact on the liquidity of share markets.

In order to avoid any circumvention of the short selling disclosure rules through off-exchange derivative transactions, the transparency regimes for EU shares and EU sovereign bonds also cover the use of derivatives to obtain a net short position relating to the shares or bonds. The proposals also require that short positions should be subtracted (or 'netted off') from long positions, as notification of a net short position provides more meaningful information to regulators and/or the market.

What powers are proposed for regulators in exceptional situations?

In distressed markets when short selling can amplify a downward price spiral, transparency alone may not be enough. The proposal provides that in exceptional situations, competent authorities (i.e. financial regulators) should have powers to impose temporary measures such as to require further transparency or to restrict short selling and credit default swap transactions. These powers extend to a wide range of instruments. The proposal seeks to harmonise the powers and define the conditions and procedures that must be complied with if the powers are to be exercised. Currently, some Member States have powers to act on short selling in exceptional situations and have used these powers, whereas others do not (see table 1). ESMA is given a central role in coordinating action in exceptional situations and ensuring that powers are only exercised where necessary (see section below on the role of ESMA).

The powers of intervention of competent authorities relating to short selling and credit default swaps in exceptional situations only contemplate temporary action (for up to a three month period). A temporary measure can be extended for further periods not exceeding three months at a time, but this must be fully justified.

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. The Commission will act by the adoption of delegated acts, and the Council and Parliament can revoke this delegation of powers or object to a delegated act within two months.

Competent authorities are also given the power in the case of a significant fall in the price of a financial instrument or class of financial instruments to impose a very short restriction on short selling of the financial instrument. Such a 'circuit breaker' power would enable competent authorities to intervene if appropriate to ensure that short selling does not contribute to a disorderly price fall in the instrument concerned.

What role is proposed for ESMA to ensure coordination in exceptional situations?

ESMA is given an important role in coordinating action in exceptional situations. Competent authorities must notify ESMA of the measures they propose to take (or renew) in such a situation, not less than 24 hours before the entry into force of the measures (this period may be shorter in exceptional circumstances). ESMA shall consider the information received and issue an opinion (within 24 hours) on whether the measure or proposed measure is appropriate and proportionate to address the threat, and whether measures by other competent authorities are necessary. Where a competent authority takes action contrary to ESMA's opinion it shall publish a notice giving its reasons for doing so.

However, ESMA may itself take action where two conditions are fulfilled: there is a threat to the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the Union and there are cross border implications; and measures have not been taken by competent authorities, or are not sufficient, to address the threat. The measures which ESMA can take and the requirements to notify regulators are the same as those foreseen for national competent authorities. A measure adopted by ESMA in accordance with is powers of intervention shall prevail over any previous measures taken by a competent authority.

What is proposed for the regulation of naked short selling?

In order to reduce the risks of settlement failures and increased price volatility which can be associated with naked short selling of shares and sovereign debt, certain requirements are introduced. In order to enter a short sale, an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party who has located and reserved them so that that they are delivered by the settlement date. This is known as a 'locate rule'. To deter settlement failures, trading venues must also ensure that there are adequate arrangements in place for buy in of shares or sovereign debt where there is a settlement failure, as well as for fines and a prohibition on short selling for late settlement. This approach addresses the risks of settlement failure while taking into account existing best practice in many markets, which is for firms to locate shares for borrowing prior to executing a short sale order.

What enforcement powers for regulators are proposed?

The proposal provides for competent authorities to have all the powers necessary, as well as rules on administrative measures, sanctions and pecuniary measures, to enforce the proposals. ESMA is also given the power to conduct inquiries into specific issues or practices relating to short selling and to publish a report setting out its findings. As certain measures may involve monitoring or enforcement against persons outside the European Union, EU regulators are required to reach cooperation agreements with regulators in third countries where EU shares or sovereign bonds and associated derivatives are traded.

Are any exemptions proposed?

Yes, for market making activities, for primary market operations and for shares whose principal market is outside the EU. Market making includes providing price quotes for financial instruments to provide liquidity to the market or to fulfil client orders. Market making activities are exempt because they play an important role in providing liquidity, and restricting their ability to short sell would have a significant adverse effect on the liquidity of markets. Primary market operations are transactions performed by dealers to provide liquidity to issuers of sovereign debt and for the purposes of stabilisation schemes (i.e. share issues intended to stabilise a share price) under the Market Abuse Directive. Primary market operations are legitimate functions that are important for the proper functioning of primary markets. Shares whose principal market is outside the European Union are exempt, because it would not be proportionate to apply short selling requirements where most trading of the share takes place outside the Union.

Does the proposal envisage a ban on so called "naked CDS"?

A "naked CDS" refers to the situation where the CDS is used by the buyer not to hedge a risk but to take a position (take risk). The seller of the CDS would gain if the credit risk did not materialise; whereas the buyer of the CDS would gain if the price of the CDS subsequently increases due to a perception by the market of an increased risk of default of the issuer.

The proposal does not provide for a permanent ban on naked CDS as the Commission considers that this would be disproportionate as it could negatively affect the liquidity of sovereign debt markets. However, the proposals do provide for:

* Greater transparency so that persons with significant naked CDS positions relating to sovereign debt issuers must notify regulators of their positions. This will enable regulators to monitor whether such positions are creating disorderly markets or systemic risks or being used for abusive purposes.
* Powers for regulators to obtain information in individual cases about CDS transactions.
* Powers of intervention in an exceptional situation for a competent authority to temporarily prohibit or restrict the use of CDS. Such measures would be temporary in nature and subject to coordination by ESMA.

What work has been done at international level on short selling, and notably in the United States?

The International Organisation of Securities Commissions (IOSCO) adopted in June 2009 a 'Final report on regulation of short selling' (3) which sets out the following four principles for the regulation of short selling:

* Short selling should be subject to appropriate controls to reduce or minimise the potential risks that could affect the orderly and efficient functioning and stability of financial markets;
* Short selling should be subject to a reporting regime that provides timely information to the market or to market authorities;
* Short selling should be subject to an effective compliance and enforcement system; and
* Short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development.

The Commission believes that its proposals on short selling are fully compatible with the principles outlined by IOSCO.

The United States has had in place a number of measures in relation to short selling which have been revised several times over the years, notably an uptick rule (which was abolished in 2007). In 2004, the SEC adopted Regulation SHO (4) which introduced the following requirements for short selling: a 'locate' rule for short sellers, a flagging regime and a "close-out" requirement for short positions. On 24 February 2010 the SEC adopted the "revised uptick" or "circuit breaker" rule. This rule restricts short sales of a share whose price has fallen by more than 10% compared to its closing price the previous day.

During the financial crisis, the SEC introduced a number of temporary emergency measures, such as a temporary "pre-borrow" requirement on short selling of shares in 19 systemically important financial institutions on 15 July 2008 (5). On 18 September the SEC imposed a temporary ban on short sales of 799 financial stocks (6), which grew to 1000 issuers. Since 1 August 2009, the SEC has been working with self-regulatory organisations to make short selling volume and transaction data available to the public through the latter's web sites. The Wall Street Reform Act enacted into law by the US President on 21 July 2010 includes certain provisions on short selling, notably it requires the SEC to adopt rules for public disclosure, at least monthly, of the amount of short sales by institutional investment managers.

Regarding CDS and especially sovereign CDS, no specific measures have been adopted by the US authorities for the time being. However, CDS fall within the scope of the Wall Street Reform Act, and the CFTC and SEC will be expected to produce joint rules to implement this.

Hong Kong also has in place measures relating to short selling: a flagging requirement with daily publication of aggregate data on short selling volume, an uptick rule, a locate rule and buy in procedures and fines in case of non-settlement.

The Commission considers that the adoption of its proposals on short selling and CDS would increase the convergence of the EU's regulatory framework with that of the United States and Hong Kong. A comparison of the EU's proposals with the measures in force in the United States and Hong Kong is included in table 2 below.

What is the proposed timing for adoption of a legislative proposal?

The proposal now passes to the European Parliament and the Council for adoption. Once adopted the regulation would apply from 1 July 2012.

In the context of the proposal to revise the Markets in Financial Instruments Directive (MiFID), due in the first quarter of 2011, the Commission will consider options including transaction reporting, position reporting and the possibility of position limits, which could complement the short selling proposals by providing additional tools to detect and guard against possible systemic risks and risks to market integrity.

In the context of the proposal to revise the Market Abuse Directive, due in the first quarter of 2011, the Commission will consider the option to extend the prohibition of market manipulation to all over the counter instruments, including derivatives, which could impact the prices of financial instruments traded on a regulated market or Multilateral Trading Facility. This option would complement this initiative by providing regulators with the tools to sanction possible market manipulation of underlying bond markets through CDS.


1  : Full text of ESME report

2 : Page 7 of the Communication of 2 June 2010 from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the European Central Bank.

3 : Text of final report

4 : Regulation SHO, Securities and Exchange Commission, 17 CFR PARTS 240, 241 and 242 [Release No. 34-50103; File No. S7-23-03]

5 : SEC Release 34-58166, Emergency Order Pursuant to Section 12(k)(2) of The Securities Act of 1934 Taking Temporary Action to Respond to Market Developments, July 15, 2008

6 : SEC, Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments Release 34-58572. September 17, 2008.

Short selling - further information - EC

Source: European Commission