Documents considered by the Committee on 20 October 2010 - European Scrutiny Committee Contents


3 Financial services

(31956)

13840/10

+ ADDs 1-2

Draft Regulation on short selling and certain aspects of credit default swaps

Legal baseArticle 114 TFEU; co-decision; QMV
Document originated15 September 2010
Deposited in Parliament22 September 2010
DepartmentHM Treasury
Basis of considerationEM of 22 September 2010
Previous Committee ReportNone
Discussion in CouncilNot yet known
Committee's assessmentPolitically important
Committee's decisionNot cleared; further information requested

Background

3.1 The Commission held a four week public consultation on short selling,[12] during June and July 2010, following both the various restrictions on short selling imposed by most Member States in the autumn of 2008 and the concerns expressed by some governments about the possible role played by credit default swaps in relation to the prices for Greek sovereign bonds in the spring of 2010.[13]

The document

3.2 With this draft Regulation the Commission proposes introduction of a number of permanent measures, as well as some temporary measures to be employed in adverse circumstances, in relation to the short selling of financial instruments.

3.3 The permanent measures the draft Regulation would introduce are:

  • a two-tiered disclosure regime for equities, in line with the recommendations made by the Committee of European Securities Regulators — persons (both natural and legal) would be required to notify the relevant competent authority if they had a net short position equal to 0.2% of the value of the issued share capital of the company concerned and each 0.1% above that, to disclose to the public details of their net short position if it equalled 0.5% of the value of the issued share capital of the company concerned and each 0.1% above that and to disclose if the person's net short position were to fall below each threshold;
  • a private disclosure regime for significant net short positions in sovereign debt — persons would be required to notify the relevant competent authority of significant net short positions relating to the issued sovereign debt of a Member State or of the EU. As with the equities disclosure regime, a threshold would be set at an initial amount and then incremental amounts above that. A disclosure would also be made when the person's net short position falls below each threshold. The Commission would set the disclosure thresholds at a later stage by means of a delegated act and they might be different for each Member State;
  • a similar private disclosure regime for 'naked' (or 'uncovered') sovereign credit default swaps. A sovereign credit default swap can be said to be 'naked' if the buyer of protection does not own direct exposure to the underlying sovereign debt. Naked credit default swaps are covered in the draft Regulation because they are the economic equivalent of shorting a debt instrument;
  • a requirement for competent authorities to summarise the information they have gathered through the disclosure regime and relay this to the European Securities and Markets Authority on a quarterly basis — the authority would be able to request additional information about net short positions relating to shares, sovereign debt or naked credit default swaps from a competent authority, which would be required to provide this within seven calendar days;
  • a requirement for persons trading on a trading venue (a regulated market such as the London Stock Exchange or a multilateral trading facility such as Chi-X Europe Ltd) to mark their short sales on that venue — this would allow individual trades to be identified as short sales. The trading venue is then required to publish at least daily a summary of the volume of orders marked as short orders;
  • restrictions on the naked short selling of shares and sovereign debt — one of three conditions would have to be fulfilled: either the shares or sovereign debt instrument are borrowed, the person has entered into an agreement to borrow the shares or instrument or the person has an arrangement with a third party under which that third party has confirmed that the shares or instrument has been located and reserved for lending so that settlement can be effected when it is due. The Commission would further clarify the types of agreements or arrangements meant;
  • exemption from the proposed disclosure obligations, the marking regime and the restrictions on naked short selling for market makers, who use short selling to fill client orders when the stock they need is not immediately available, and for authorised primary dealers, who act similarly in the sovereign debt market;
  • a requirement for trading venues or central counterparty clearing houses to introduce mandatory buy-in procedures and fines for late settlement. Where the short seller were not able to deliver the shares or sovereign debt instrument for settlement within four working days after the day on which the trade took place, or six trading days after the day on which the trade took place in the case of market making activities, then, in order to ensure delivery for settlement, the trading venue or clearing house would have to buy-in the shares or instrument. If this were not possible, then cash compensation would have to be paid to the buyer based on the value of the shares or debt to be delivered at the date due plus an amount for any losses incurred by the buyer. The short seller who failed to settle would have to repay all the costs incurred by the trading venue or clearing house and would have the obligation to make daily payments (in effect, a fine) for each day that the failure continued;
  • an obligation for competent authorities to cooperate with each other, including entering into agreements with competent authorities in countries both inside and outside the EU to exchange information and facilitate enforcement; and
  • a role for the European Securities and Markets Authority in coordinating investigation or inspection where that concerned more than one Member State.

3.4 The transparency requirements would apply regardless of where the person were located, including where the person were located outside the EU, but had a significant net short position in a company that had shares admitted to trading on a trading venue in the EU or a net short position in sovereign debt issued by a Member State or the EU. The disclosure regime would not apply to short positions in companies where the principal venue for trading their shares is outside the EU. The restrictions on naked short selling and the buy-in procedures and fines for late settlement would not apply to shares of a company admitted to trading on a trading venue in the EU where the principal venue for the trading of the shares were located in a third country. The European Securities and Markets Authority would have to publish a list of such exempt shares every two years.

3.5 The draft Regulation would give competent authorities and the European Securities and Markets Authority power to introduce a variety of temporary measures, where there were adverse developments. The authority could take such action when the orderly functioning and integrity of financial markets or the stability of whole of part of the EU financial system was under threat. Competent authorities could take action when there was a serious threat to financial stability or to market confidence in the Member State or its neighbours or in the EU.

3.6 In connection with temporary measures taken by competent authorities the draft Regulation would introduce:

  • the power, in defined adverse situations, for a competent authority to introduce a disclosure regime covering short positions in all financial instruments, to prohibit or impose conditions on short selling and to prevent persons from entering into transactions relating to financial instruments or limiting the value of permissible transactions. The competent authority would be free to set parameters, by applying these restrictions to transactions in a specified share, or class of shares, or in other specified circumstances, which are not further defined, would be able to provide for exemptions in specified cases and would be able to impose equivalent restrictions on credit default swap transactions relating to sovereign debt;
  • a requirement for the competent authority to notify the European Securities and Markets Authority and other competent authorities of its intention to take any of those measures at least 24 hours before the action was to be taken, unless that were simply not possible or in the case of an introduction of a circuit-breaker — this would allow other competent authorities to consider taking similar action;
  • a requirement, within 24 hours of notification, for the European Securities and Markets Authority to respond with an opinion on whether the proposed or actual measure was necessary, justified and of the correct duration and if it considered that other competent authorities should take similar measures;
  • a requirement for a competent authority, if it proposed to take measures contrary to the European Securities and Markets Authority opinion, to publish immediately on its website a notice fully explaining its reasons for doing so;
  • a provision allowing these temporary measures to be imposed initially for a maximum three month period and to be renewed for further periods not exceeding three months at a time;
  • the power for a competent authority to prohibit short selling when the price of a share has fallen by 10% during a trading day from the closing price the previous day. This would apply to other financial instruments, with the Commission specifying in a delegated act the appropriate fall in value for financial instruments other than shares. Such a restriction, or 'circuit-breaker' would be temporary and apply for a period not exceeding the day after the price fall; and
  • a requirement for the competent authority to publish on its website notice of any decision to impose or renew any temporary measure, outlining the reasons for the actions taken and the evidence to support it.

3.7 In connection with temporary measures taken by the European Securities and Markets Authority the draft Regulation would introduce:

  • the ability of the authority to place temporary restrictions directly on both natural and legal persons when the activities carried out threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system and it was not satisfied that the competent authority or Authorities had taken adequate measures to address the threat. In such situations the European Securities and Markets Authority could prohibit persons from trading or limit the value of such trading, prohibit persons from entering into short sales or impose conditions on such sales, prohibit sovereign credit default swaps transactions, limit the value of naked sovereign credit default swaps and require public disclosure of short selling;
  • a requirement for the European Securities and Markets Authority to give competent authorities 24 hours notice of any such temporary restriction (unless, in exceptional circumstances, this were not possible);
  • requirements for the European Securities and Markets Authority, where appropriate, to consult with competent authorities and the European Systemic Risk Board before taking its decision and to review its decision at appropriate intervals and at least every three months after which, if it were not renewed, it would end;
  • the ability for the European Securities and Markets Authority to override any measures taken by a Member State, or to impose measures if the Member State had not deemed it necessary but ESMA considered such measures necessary to address a threat to the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system;
  • a requirement for the Commission to provide further clarity on the definition of such adverse events, developments and threats to the orderly functioning and integrity of the financial markets;
  • the ability of the European Securities and Markets Authority to conduct an inquiry into a particular issue or practice relating to short selling or credit default swaps to assess whether any threat was being posed by them; and
  • a requirement for the European Securities and Markets Authority to publish the findings of any such inquiry.

3.8 The proposed Regulation would be directly applicable in all Member States, is expected to apply from 1 July 2012 and would be reviewed by 30 June 2014.

The Government's view

3.9 The Financial Secretary to the Treasury (Mr Mark Hoban) tells us, in relation to the EU Charter of Fundamental Rights, that:

  • the requirement in the draft Regulation that information in relation to net short positions held by a person should be publicly disclosed might give rise to issues in relation to Article 7 (respect for private and family life) of the Charter if the information concerned is personal information — this would not usually apply (in most cases a person holding a short position would not be trading on their own account) and where it did the requirement for disclosure would be likely to be justified; and
  • the exercise of powers given to competent authorities and to the European Securities and Markets Authority in the proposed Regulation to prevent persons from entering into certain transactions might in some circumstances raise issues under Article 17 (right to property) of the Charter.

3.10 On the policy implications of the proposal the Minister first says that:

  • as the Commission acknowledges, most studies conclude that short selling contributes to the efficiency of markets, increasing market liquidity and leading to the more efficient pricing of securities and ultimately a better deal for investors;
  • the Commission also acknowledges that short selling is an important tool that is used for hedging and other risk management activities and market making; and
  • the Government supports these views.

3.11 The Minister then comments that:

  • the Government agrees that it is important that all Member States have clear and unequivocal powers to take action against short selling in adverse circumstances;
  • the UK introduced a temporary short selling prohibition in the autumn of 2008 at a time of extreme market turbulence — this temporary prohibition naturally expired in January 2009 when the market conditions prevalent had ceased, principally when the sharp share price declines in individual banks that led to pressure on their funding had normalised;
  • the Financial Services Authority maintains a disclosure regime in relation to short positions in stocks in UK financial sector companies as a proportionate response to any outstanding or future risk short selling may present;
  • short selling which is carried out in connection with abusive strategies (such as the spreading of false rumours in order to drive down prices) is already prohibited by the Market Abuse Directive;
  • the Financial Services Act 2010 gives the Financial Services Authority clear powers to take action against short selling and to impose a disclosure regime on equities;
  • therefore, the Government welcomes the Commission's proposals towards enhanced transparency requirements for equities and is supportive of the two tier disclosure regime — these proposals are in line with those of the Committee of European Securities Regulators, which the Financial Services Authority attends on behalf of the UK;
  • the Government believes any further proposals imposing restrictions or measures on short selling should be both evidence based and proportionate;
  • it is aware that no evidence has yet been presented to support a disclosure regime in sovereign bonds, or to support restrictions on credit default swaps;
  • naked sovereign credit default swaps can be used for a variety of different purposes other than insurance against actual sovereign default, such as managing the general credit exposure from that country;
  • the proposed disclosure measures and restrictions on naked short selling relating to sovereign debt have the potential for a negative impact on sovereign bond markets across the EU and ultimately on a sovereign's cost of borrowing;
  • the Government notes that these proposals give the European Securities and Markets Authority powers to intervene in UK markets, including over the UK gilt market, and believes that the power to intervene in these markets should rest with Member States due to the fiscal impact of interventions in sovereign debt markets;
  • the proposal implies significant and unmet ongoing costs for both firms and individuals, trading venues and clearing houses in establishing the infrastructure necessary to meet its requirements; and
  • the Government does not support proposed restrictions on short selling that are not evidence based and have little in the way of quantifiable benefit.

3.12 Turning to the financial implications of the draft Regulation the Minister says that the Commission's Impact Assessment identifies the risks, and therefore the costs, of short selling during adverse developments:

  • the risk of negative price spirals;
  • the risk of settlement failure associated with naked short selling;
  • transparency deficiencies; and
  • regulatory arbitrage and increased compliance costs.

In the Impact Assessment the Commission argues that these risks are likely to occur again in the future without the proposed Regulation and that uncoordinated national measures are more costly to market participants. The cost of these risks has not been quantified.

3.13 On the Commission's estimates of the costs of the proposed Regulation the Minister says that:

  • the EU-wide one-off compliance cost related to the notification and disclosure requirements of equities is approximately €137 million (£113 million);
  • annual ongoing costs are estimated to be 10% of this cost, or approximately €13.70 million (£11.30 million);
  • these costs represent investment in information technology and information systems, training and compliance procedures;
  • the ongoing annual cost of disclosure to the regulator and to the public when the relevant equities threshold is exceeded is estimated to be approximately €2.10 million (£1.73 million) — therefore, the annual EU-wide compliance cost of an equities disclosure regime (not including the one-off cost) is approximately €15.80 million (£13 million);
  • the one-off costs for the sovereign bond disclosure requirement is estimated to be in the order of €34.20 million (£28.20 million), with an annual cost of €3.40 million (£2.80 million) and, when the thresholds are exceeded, a further €1.60 million (£1.30 million) — therefore, the annual EU-wide compliance cost of a sovereign bond disclosure regime (not including the one-off cost) is in the order of €5 million (£4.10 million);
  • the administrative cost on regulators of quarterly reporting to European Securities and Markets Authority of significant net short positions in their jurisdictions, based on two hours work by a manager, is estimated to be a total annual EU-wide cost to regulators of €6,758 (£5,574); and
  • this cost does not include the cost of establishing a marking regime, because no cost estimates other than from the UK have been received — the Financial Services Regime has previously estimated that the cost to individual broking firms of establishing a marking regime would vary from several hundreds of thousand pounds to around £2 million.

3.14 On consultation the Minister says that key industry stakeholders are aware of the proposal and that the Treasury arranged a stakeholder group ahead of the first Council working group meeting.

Conclusion

3.15 It is clear that the Government has, with good reason, considerable reservations about this draft Regulation. We share these reservations. However before considering the document further, which we are likely in due course to recommend for debate, we should like to hear from the Government about:

  • discussion of the draft Regulation in the Council working group, particularly in relation to the Charter of Fundamental Rights, to the potential for fiscal consequences of European Securities and Markets Authority market interventions, to the lack of an evidence base for the proposal and to the unquantified cost of the risks being addressed; and
  • representations made to the Government by UK stakeholders.

Meanwhile the document remains under scrutiny.





12   The practice of selling assets that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to the lender and with the hope of profiting from a decline in the price of the assets between the sale and the repurchase. Back

13   A sovereign credit default swap is a contract in which one party pays a fee to another party in return for compensation or payment in the event of the sovereign experiencing a specified credit event (such as where a sovereign repudiates or declares a moratorium on paying its debt). Back


 
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