Explanatory Memorandum to COM(2010)482 - Short Selling and certain aspects of Credit Default Swaps - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2010)482 - Short Selling and certain aspects of Credit Default Swaps. |
|---|---|
| source | COM(2010)482  |
| date | 15-09-2010 |
Short selling of securities is a practice where a natural or legal person sells a security he does not own with the intention of buying back an identical security at a later point in time. It is an established and common practice in most financial markets. Typically short selling relates to shares although it can also occur in relation to other types of financial instruments.
Short selling can be divided into two types: covered short selling where the seller has borrowed the security, or made arrangements to ensure they can be borrowed before the short sale and uncovered or naked short selling where at the time of the short sale the seller has not borrowed the securities or ensured they can be borrowed.
Short selling is undertaken by a range of market participants and is used for different purposes such as hedging, speculation, arbitrage and market making.
At the height of the financial crisis in September 2008, competent authorities in several EU Member States and the USA adopted emergency measures to restrict or ban short selling in some or all securities. They acted due to concerns that at a time of considerable financial instability, short selling may aggravate the downward spiral in the prices of shares, notably in financial institutions, in a way which could ultimately threaten their viability and create systemic risks. The measures adopted by Member States were divergent as the European Union lacks a specific legislative framework for dealing with short selling issues.
Earlier this year concerns were expressed by some Member States about the possible role played by derivative transactions, notably credit default swaps, in relation to the prices for Greek sovereign bonds. A number of Member States (notably Germany and Greece) have recently adopted temporary or permanent restrictions at national level relating to short selling of shares and/or credit default swaps.
The European Parliament has also been considering short selling issues in the context of consideration of the proposed Directive on alternative investment fund (including hedge funds) managers.
The current fragmented approach to short selling and credit default swaps limits the effectiveness of supervision and the measures imposed and results in regulatory arbitrage. It may also create confusion in markets and costs and difficulties for market participants.
Most studies conclude that short selling contributes to the efficiency of markets. It 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.
But short selling can in some situations be viewed as giving rise to a number of potential risks. For example in extreme market conditions there is a risk that short selling can lead to an excessive downward spiral in prices leading to a disorderly market and possible systemic risks. Moreover, if there is insufficient transparency about short positions it can lead to regulators not being able to monitor the implications upon market orderliness or monitor the use in connection with abusive strategies. In addition, lack of transparency may lead to information asymmetries if other market participants are not adequately informed about the extent to which short selling is affecting prices. For uncovered short sales there may also be increased risk of settlement failures and volatility.
Short selling of financial instruments being used as part of an abusive strategy, for example the use of short sales in connection with the spreading of false rumours to drive down the price of a security, is already prohibited under the Market Abuse Directive 2003/6/EC i. However, short selling is often not abusive and there is currently no European legislation dealing with other potential risks that might arise from short selling.
A credit default swap is a derivative which provides a form of insurance against the risk of credit default of a corporate or government bond. In return for an annual premium, the buyer of the credit default swap 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 the default.
In the Commission's communication of 2 June 2010 on Regulating Financial Services for Sustainable Growth, the Commission stated that it will propose appropriate measures on short selling and credit default swaps i. This would be based on the findings of an ongoing investigation into the functioning of financial markets and in particular sovereign debt markets.
A number of jurisdictions (such as the USA) have recently updated their rules applying to short selling of shares conducted on trading venues. The Commission considers it is desirable to have a regulation addressing the potential risks arising from short selling. The intention is to harmonise requirements relating to short selling across the European Union, harmonise the powers that regulators may use in exceptional situations where there is a serious threat to financial stability or market confidence and ensure greater co-ordination and consistency between Member States in such situations.
The regulation should apply to all natural or legal persons who engage in short selling, across all market sectors, and whether regulated by other pieces of financial services regulation (e.g. banks, investment firms, hedge funds etc) or unregulated. As far as possible, the requirements should apply to the natural or legal persons entering into short sales rather than to other market participants such as intermediaries who execute a transaction for a client. The regulation aims at addressing the identified risks without unduly detracting from the benefits that short selling provides to the quality and efficiency of markets.
Contents
- RESULTS OF CONSULTATIONS WITH THE INTERESTED PARTIES AND IMPACT ASSESSMENTS
- LEGAL ELEMENTS OF THE PROPOSAL
- BUDGETARY IMPLICATION
- 3.1. Legal basis
- 3.2. Subsidiarity and proportionality
- 3.3. Detailed explanation of the proposal
- 3.3.1. Instruments covered by the proposals
- 3.3.4. Exemptions - Articles 14 and 15
The initiative is the result of an extensive dialogue and consultation with all major stakeholders, including securities regulators and market participants.
The Commission asked the European Securities Markets Expert Group (ESME), an independent advisory group to the Commission composed of market participants, to prepare a report on short selling. The report contains a series of recommendations and was adopted by ESME on 19 March 2009 i.
In April 2009, the European Commission asked some general questions about a possible regulatory regime for short selling in the context of a call for evidence on the review of the Market Abuse Directive launched on 20 April 2009 i. There was some support for such a regime although most contributors considered that the Market Abuse Directive was not the appropriate instrument for addressing short selling, as most short selling does not involve market abuse i.
The Committee of European Securities Regulators (CESR) consulted in the second half of 2009 on a possible pan-European model for the reporting and disclosure of net short positions in EU shares. On 2 March 2010 CESR published its final report recommending a model for a pan-European short selling disclosure regime for shares i. It recommended that the Commission introduce such a regime as soon as possible. On 26 May 2010 CESR published a further report setting out further technical details about how the model should operate i.
The Commission had a number of discussions and consultations with various stakeholders including regulators i.
From 14 June to 10 July 2010, the Commission launched a public consultation on policy options for a possible legislative initiative on short selling and credit default swaps. The Commission received around 120 contributions which have been published on the Commission's website i.
The proposals take into account the work of ESME and CESR and responses to questionnaires sent to market participants and regulators and responses to the relevant public consultations.
In line with its 'Better Regulation' policy, the Commission conducted an impact assessment of policy alternatives. Policy options related to the scope of the proposals, the proposed transparency regimes, requirements relating to uncovered short selling, exemptions and exceptional powers to restrict short selling.
Each policy option was assessed against the following criteria: impact on stakeholders, effectiveness and efficiency.
The proposal is based on Article 114 of the TFEU.
The objectives of the proposal cannot be sufficiently fulfilled by the Member States.
According to the principle of subsidiarity (Article 5.3 of the TFEU), action on EU level should be taken only when the aims envisaged cannot be achieved sufficiently by Member States alone and can therefore, by reason of the scale or effects of the proposed action, be better achieved by the EU. The preceding analysis has shown that although all the problems outlined above have important implications for each individual Member State, their overall impact can only be fully perceived in a cross-border context. This is because short selling a financial instrument can be carried out wherever that instrument is listed, or over the counter, so even in markets other than the primary market of the issuer concerned. Moreover, many markets are by their nature cross border or international. Therefore, there is a real risk of national responses to short selling and credit default swaps being circumvented or ineffective in the absence of EU level action.
The divergent responses of Member States to issues relating to short selling pose the risk of regulatory arbitrage, as investors could seek to circumvent restrictions in one jurisdiction by carrying out transactions in another. This regulatory fragmentation could also lead to increased compliance costs for market participants, especially those operating on several markets, who would have to set up different systems to comply with different requirements in different Member States.
Furthermore, certain aspects of this issue are already partly covered by the acquis , notably: the Market Abuse Directive 2003/6/EC which prohibits short selling which is used to manipulate the market or in conjunction with insider information; the Transparency Directive 2004/109/EC i, which requires the disclosure of significant long positions; and the Markets in Financial Instruments Directive ('MIFID') 2004/39/EC i which imposes high level requirements regarding settlement arrangements. This proposal on short selling and these existing legal instruments should complement each other. This can best be achieved by common EU rules.
Against this background EU action appears appropriate in terms of the principles of subsidiarity and proportionality.
It is considered appropriate and necessary for the provisions to take the legislative form of a Regulation as some provisions impose direct obligations on private parties to notify and disclose net short positions relating to certain instruments. A Regulation is also necessary to confer powers on ESMA to coordinate measures by competent authorities and to take measures itself in exceptional situations where there is a serious threat to the orderly functioning and integrity of financial markets or the stability of the financial system. Moreover, the use of a Regulation will restrict the possibility of divergent measures being taken by competent authorities.
The proposal covers all financial instruments but provides for a proportionate response to the risks that that short selling of different instruments may represent.
For instruments such as shares and derivatives relating to shares, sovereign bonds and derivatives relating to sovereign bonds and credit default swaps relating to sovereign issuers where taking short positions is more common and there are clearly identifiable risks or concerns, transparency requirements and requirements relating to uncovered short selling are applied.
In exceptional situations where there is a serious threat to financial stability or market confidence, the proposal provides for the possibility to impose further transparency measures on a temporary basis for other financial instruments.
3.3.2. Transparency requirements for short positions in certain instruments – Articles 5 to 11
The proposal applies transparency requirements to natural or legal persons with significant net short positions relating to EU shares and EU sovereign debt and to natural or legal persons with significant credit default swap positions relating to EU sovereign debt issuers.
The proposal for share transparency is based on the model recommended by CESR i. 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. Notification to regulators should enable them to monitor and if necessary investigate short selling that may create systemic risks or be abusive. Publication of information to the market should provide useful information to other market participants about significant individual short selling positions.
As regards significant net short positions relating to sovereign debt issuers in the EU, private disclosure to regulators is required. Disclosure to regulators of such positions will provide important information to assist regulators in monitoring whether such positions are creating systemic risks or being used for abusive purposes. The regime also provides for notification of significant positions in credit default swaps that relate to EU sovereign debt issuers.
In order to enable the ongoing monitoring of positions, the transparency regimes require notification and/or disclosure where a change in a net short position results in an increase or decrease above or below certain thresholds.
The transparency requirements apply not only to short positions created by trading of shares or sovereign debt on trading venues but also to short positions created by trading outside trading venues (so called OTC-trading) and economic net short positions created by the use of derivatives such as options, futures, contracts for differences and spread bets relating to shares or sovereign debt.
The transparency requirements aim at ensuring that information provided to regulators and the market is complete and accurate. For example, information provided should take into account both short and long positions so that it provides meaningful information about the natural or legal person's net position.
As the transparency regimes will involve detailed and technical calculation of individual positions, the proposal provides for further technical details to be adopted by the Commission in delegated acts.
In addition to the transparency regime for the notification and disclosure of net short positions for shares, the proposal includes a requirement for the marking of short orders. A requirement for the marking or flagging of sell orders executed on trading venues as short orders where the seller is entering into a short sale of shares on that venue will provide additional information about volumes of short sales executed on the trading venue. 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.
3.3.3. Uncovered short sales – Articles 12 and 13
Uncovered or naked short selling of shares and sovereign debt is sometimes viewed as increasing the potential risk of settlement failure and market volatility. The proposals include detailed requirements aimed at addressing these risks. To this end, natural or legal persons entering into short sales of such instruments must at the 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 that are currently used to enter into covered short selling and which ensure that securities will be available for settlement. For example, some participants make arrangements with a prime broker before entering into the sale to ensure securities are available for settlement while others have existing arrangements with securities settlement systems that ensure the securities will be available for settlement. In this context, the Commission is given the power to adopt further standards about the agreements to borrow and other arrangements under this requirement.
Furthermore, 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.
However, the general issue of harmonisation of settlement periods and arrangements is a separate and broader issue that will be more fully considered in the context of other specific initiatives (such as the forthcoming Directive on legal certainty of securities holding and transactions as announced in the Commission's Communication of 2 June 2010).
In order to reflect the principle that all measures should be proportionate and address the risks of short selling without inadvertently harming legitimate activities that are beneficial to the efficiency and quality of European markets, a certain number of exemptions are included in the proposals.
An exemption is provided for shares of a company where the principal market for the shares is outside the European Union. This reflects that fact that shares in companies are increasingly traded on a number of different trading venues around the world. For example, many large overseas companies have shares traded not only on their home market but on a trading venue in the European Union. It is not appropriate or proportionate to apply short selling requirements where most trading of the share takes place outside the Union. This is potentially onerous for market participants and creates unnecessary complexity that may discourage issuers from having their shares traded on venues in the European Union.
An exemption is also provided for market making activities. Market making activities play a crucial role in providing liquidity to European markets and market makers need to take short positions to perform this role. Imposing requirements on such activities could severely inhibit the ability to provide liquidity and have a significant adverse impact on the efficiency of European markets. Moreover, market makers generally do not take significant short positions except for during very brief periods. This exemption is intended to cover the different types of market making activities. However, proprietary trading is not excluded and consequently fully covered by the proposal. Competent authorities are required to be notified by persons wishing to use this exemption and may prohibit a person from using the exemption if the person does not fulfil the relevant criteria in the exemption. Competent authorities may also demand further information from a person using the exemption.
An exemption is also provided for primary market operations performed by dealers in order to assist issuers of sovereign debt or for the purposes of stabilisation schemes under the Market Abuse Directive. Like market making, these are legitimate functions that are important for the proper functioning of primary markets.
4.3.5. Intervention powers – Articles 16 to 25
The proposals recognise that in exceptional situations it may be necessary for competent authorities to prohibit or restrict short selling activities that would otherwise be legitimate or pose minimal risks. The proposal provides that in the case of adverse developments which constitute a serious threat to financial stability or to market confidence in a Member State or the European Union, competent authorities should have temporary powers to require further transparency or to impose restrictions on short selling and credit default swap transactions or limit natural and legal persons from entering into derivative transactions. These powers extend to a wide range of instruments. The proposals attempt to harmonise the powers and the conditions and procedures for use of the powers as much as possible.
Where an adverse development or event creates a threat to financial stability or market confidence that extends beyond one Member State or has other cross border implications, it is essential that there is close consultation and co-operation between competent authorities. The proposal introduces various procedural requirements aimed at ensuring that other competent authorities are notified if a competent authority intends to take exceptional measures related to short selling. The European Securities Market Authority (ESMA) is given a key co-ordination role in such a situation to try to ensure consistency between competent authorities. In addition to co-ordinating measures by competent authorities, ESMA will ensure that such measure is only taken where it is necessary and proportionate to do so. ESMA is required to issue an opinion on any proposed measure.
These measures should allow for swift reactions by national regulators in exceptional situations while ensuring consistency. ESMA would make sure that situations with cross-border effects would receive – to the extent possible - the same treatment, thus reducing the possibility of regulatory arbitrage and instability in the markets.
The powers of competent authorities to restrict short selling, credit default swaps and other transactions contemplate temporary measures (usually for up to a three month period) to the extent necessary to deal with the exceptional situation. Such a measure can be extended for further periods of three months at a time if the conditions for use of the power and procedural requirements are complied with. ESMA is required to issue an opinion and ensure that any extension can be justified.
In order to ensure a consistent approach to the use of the powers of intervention, the Commission is given the power to further define by means of delegated acts criteria and factors that must be taken into account by competent authorities and ESMA in determining when adverse events or developments create a serious threat to financial stability or market confidence.
In the case of a significant fall in the price of a financial instrument, competent authorities are given the power to impose a very short prohibition on short selling of the instrument or otherwise limit transactions to prevent a disorderly decline in the price. Such a circuit breaker power should enable competent authorities to intervene if appropriate for a very short period to ensure that short selling does not contribute to a disorderly price fall in the instrument concerned. This power would be triggered by objective criteria and would not require an assessment of whether there is a serious threat to financial stability or market confidence.
Finally, although the proposal assumes that competent authorities often will be best placed to deal initially with exceptional situations in which there is a threat to financial stability or market confidence and gives ESMA a strong coordination role in such cases, it also confers powers on ESMA to take temporary measures in such a situation. ESMA is given the power to take measures where the situation has cross border implications and competent authorities have not adequately addressed the threat. ESMA can take the same types of measures as the competent authorities. In such cases, ESMA is required to notify competent authorities and market participants. Any measure taken by ESMA in such situations would override measures by competent authorities if there is any inconsistency.
The powers foreseen specify the powers of ESMA in case of short selling and are without prejudice to ESMA's general powers as set out in Regulation [ESMA …/2010].
3.3.6. Powers and sanctions – Articles 26 to 35
The proposal gives competent authorities all the powers necessary for the enforcement of the rules. For example, the powers cover access to documents, the right to obtain information from natural or legal persons and to take enforcement action.
In individual cases, competent authorities are given the power to request further information from natural or legal persons about the purpose for which a credit default swap transaction is entered into and to request information verifying that purpose.
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 natural or legal persons outside the Union, EU regulators should be encouraged to reach cooperation agreements with regulators in third countries where EU shares or sovereign bonds and associated derivatives are traded. This would facilitate the exchange of information and enforcement of the obligations, as well the taking of similar measures by third country regulators in exceptional situations where there is a serious threat to financial stability or market confidence in the Union. ESMA should play a role in coordinating the development of cooperation agreements and the exchange of information received from third country regulators.
The proposal requires Member States to provide for rules on administrative measures, sanctions and pecuniary measures necessary for the implementation and enforcement of the proposal.
The proposal has no implication for the Union budget.