A curious story emerged on 11 April 2017 when a man was charged with planting a bomb under the Borussia Dortmund football club team bus in April. It was initially suspected to be the work of terrorists but the truth was actually much stranger—it was a short seller. The man, a 28-year old known only as Sergei W, set the bomb to profit from 15,000 put options he had purchased in anticipation of the club's share price slumping post-attack. Ironically, the damage from the bomb was shrugged off in the financial markets. The club's shares fell further after Dortmund had been eliminated from the Champion's League the week after the attack then on that particular day. This odd tale might confirm the nefarious reputation that many short sellers have in the public eye.
The financial crisis in 2008 initiated a global recession which eventually, but only partly contributed to the sovereign debt crisis in the Eurozone. It was argued in the Liikanen Report of 2012 that these events should provide an impetus for the legislative reforms concerning the financial and capital markets in the European Union. The group further emphasized that even though the reforms are, by nature, pre-emptive, the aim shall be to provide authorities with tools that would effectively control the market disorders prevalent today. The distinctive objective is to create a market infrastructure in which the efficient capital allocation would not be suppressed, and in which systemic risks could be monitored and managed properly to protect the economic stability of the Member States. In consequence, the European Commission had proposed about 30 sets of rules since 2010 regarding the common financial and capital markets in the European Union (EU). The most essential of the reforms includes the implementation of Basel 3 framework into the EU banking regulation (CRD IV). Others that furthered global collaboration int his regard include the European Market Infrastructure Regulation (EU) No 648/2012 and Alternative Investment Fund Managers Directive (2011/61/EU), which provide comprehensive rules for over-the-counter derivatives trading and the business activity conducted by the property, private equity, commodity, and hedge funds. As Dobravolskas and Seiranov in 2011 address, the “regulatory reforms are reaction to market failures” and the evolution of regulation can be comprehended as a long regulatory cycle where “periods of tightened regulation are changed with lax regulation or deregulation”. Quite interestingly, the previous financial markets regulatory cycle in the EU from 1999 to 2004 also addressed issues such as supervision, supranational regulation and harmonized frameworks (Quaglia 2007), but was unable to provide sufficient systemic resiliency against the upcoming meltdown in 2008.
In the immediate aftermath of Lehman Brothers' collapse both the United States (US) Securities and Exchange Commission and the regulatory body of the United Kingdom (UK), the Financial Services Authority had temporarily banned short selling to protect the markets and reduce downward pressure on prices. The ban covered 29 financial stocks in the London Stock Exchange and eventually over 900 stocks in the US. Subsequently, 24 other countries enforced varying constraints on short-selling between September and October in 2008. Following the diversified measures by regulatory bodies, it was reported that market participants had been negatively affected by the numerous and varying rulebooks across market places, while inversely, other, usually larger institutional market participants benefitted from regulatory arbitrage. The report formed the basis for the legislative process that would eventually lead to the introduction of Regulation (EU) No 236/2012 on Short Selling and Certain Aspects of Credit Default Swaps, which became fully applicable on 1 November 2012.
Regulation is aimed to achieve the following:
- increasing the transparency of short positions,
- reducing settlement risk and other risks linked with uncovered or naked short selling,
- reducing risks to the stability of sovereign debt markets posed by uncovered (naked) Credit Default Swaps (CDS) positions, while providing for the temporary suspension of restrictions where sovereign debt markets are not functioning properly,
- ensuring that the competent authorities 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,
- ensuring coordination between the Member States and the European Securities and Markets Authority (ESMA) in exceptional situations.
The short-selling regulation consists of Regulation (EU) No. 236/2012 as well as the Implementing Regulations and Delegated regulations that implement the so-called technical standards. Technical standards regarding the further implementation of short-selling regulation are represented by either the RTS (Regulatory technical standards) or ITS (Implementing technical standards). The short-selling regulation has four technical standards, ImplementingRegulation (EU) 827/2012 and delegated regulations-(EU) 826/2012, (EU) 918/2012 and (EU) 919/2012. A new framework regarding short-selling of financial instruments and transactions in credit default swaps was introduced with the short selling regulation. The regulation requires holders of net short positions in shares or sovereign debt to make notifications once certain thresholds have been breached. It also outlines further restrictions on investors entering into uncovered short positions in shares or sovereign debt.
The practice of short selling under the new regulatory regime is the prohibition of naked short selling. According to Preamble 18 of the Regulation the “uncovered short-selling of shares and sovereign debt is sometimes viewed as increasing the potential risk of settlement failure and volatility”, and to reduce such risks “it is appropriate to place proportionate restrictions on uncovered short selling of such instruments”. In consequence, the Regulation mandates either the borrowing, or the arrangement of the borrowing with a third party that confirms that the securities have been located before entering into a short position. Thus, prohibition of naked positions applies equally to equity and sovereign debt instruments. Concerns regarding the stability of sovereign debt markets on one hand and the excessive sovereign debt of certain member states on the other have been highlighted since the escalation of the European debt crisis. Due to the possible adverse impact on debt market stability, regulation now prohibits purchasing credit default swaps without having a long position in underlying sovereign debt instrument. Thus, sovereign credit default swaps shall be based on the insurable interest principle; the only legitimate reason to enter into a CDS contract is to hedge against the default risk of the issuer, which naturally requires ownership in the underlying security. Conversely, should a natural or a legal person buy a credit default swap without purchasing the underlying debt instrument first, it would be in his best interest that the issuer defaults. Further practical change is the obligation to report and disclose significant net short positions tonational competent authorities (NCA) and the public, respectively. Apart from exemptions granted for market makers and authorized primary dealers, the reporting requirement applies to every market participant, but for a predefined threshold, i.e. if a significant net short position in shares equals or exceeds 0.2 percent of issued share capital. Notification obligation further applies to every 0.1 per cent change above the threshold. Notification must be made public if the net short position in shares exceeds 0.5 percent of the issued share capital of a company and for each 0.1 percent above that. Notifications must be made privately or in public when a net short position falls below the aforementioned limits.
Notification must be made to the competent authorities when net short positions in sovereign debt instruments exceed or falls below certain limits. Where the total amount of outstanding debt of a state is in the range of 0 to 500 billion euros, the notification limit is 0.1 percent. Where the total amount of outstanding debt of a state is over 500 billion euros or where there is a market with futures for the issued sovereign debt instruments of that State, and the market is considered liquid, the notification limit is 0.5 percent. Notification must be made each time the net short position is increased by 0.05 percent above the 0.1 percent level and when the net short position is increased by 0.25 percent above the 0.5 percent level. The threshold for Iceland is 0.1 percent.
The purpose of the reporting obligation is twofold. First, it enables ESMA to monitor market moves in general and large positions in particular, and in consequence manage risks that dwell within. Secondly, NCAs are required to disclose reported net short positions in shares in a comprehensive and easily accessible manner, which shall be expected to contribute to more transparent market fluctuations. The disclosure threshold is set at 0.5 percent of issued share capital, and each 0.1 percent move above the initial threshold, also is further disclosed. Authorities should disclose more detailed and timely information on short positions as it provides more accurate picture of the market sentiment, thus increasing the pricing efficiency. Based on trading data from 913 Nasdaq-listed stocks, it was concluded that short sellers are information-oriented traders, the results showed that abnormal short-selling activity before the earnings announcement was significantly linked with the stock price reaction after the earnings went public, indicating a positive relationship between overvalued stocks and short sale volume. The Regulation also provides NCAs with an authorization to enforce temporary bans or introduce other constraints of similar effect, provided it notifies ESMA beforehand, which then coordinates and implements the proposed measures. However, according to Article 28(1), ESMA is permitted to disregard any NCA and directly order emergency measures and conduct direct operational decisions anywhere in the European Economic Area. Intervention may only take place, however, if market conditions favor taking measures. Such conditions pose an apparent threat to the functionality of financial markets or to the stability of the whole or part of the financial system in the Union (“cross-border implications”). Interestingly, the European Court of Justice (ECJ) rejected the UK's lawsuit in January 2014. In the case United Kingdom of Great Britain and Northern Ireland v. Council of the European Union, European Parliament”, the UK argued that emergency powers handed to ESMA were illegal and that constraints on short-selling harm market efficiency. The ECJ ruled that the new powers were compatible with EU law, dismissing the legal case in its entirety.
The legal mandate for the competent authority to prohibit or impose conditions to natural or legal persons entering into a short sale is provided in Article 20(2). Measures are further applicable to transactions concerning all financial instruments and transactions other than short sales, provided the pursued effect of the transaction is to confer a financial advantage in the event of a decrease in price or value of another financial instrument. Under Article 20(1)(a), the definition of exceptional circumstances is proportional to the market preconditions that include adverse events or developments which constitute a serious threat to financial stability or market confidence in one or more Member States. Article 24(1) of Commission Delegated Regulation (EU) No 918/2012 supplements the Regulation with specific characteristics of adverse events and developments. They include any act, result, fact, or event that is or could reasonably be expected to cause serious financial, monetary or budgetary problems which may lead to financial instability concerning a Member State or a bank and other financial institutions deemed important to the global financial system; a rating action or a default by any Member State or banks and other financial institutions deemed important to the global financial system that causes or could reasonably be expected to cause severe uncertainty about their solvency; substantial selling pressures or unusual volatility causing significant downward spirals in any financial instrument related to any banks and other financial institutions and sovereign issuers deemed important to the global financial system; any relevant damage to the physical structures of important financial issuers, market infrastructures, clearing and settlement systems, and supervisors which may adversely affect markets in particular where such damage results from a natural disaster or terrorist attack; and any relevant disruption in any payment system or settlement process, in particular when it is related to interbank operations, that causes or may cause significant payments or settlement failures or delays within the Union payment systems, especially when these may lead to the propagation of financial or economic stress in a bank and other financial institutions deemed important to the global financial system or in a Member State. Lastly, additional consideration should be paid to the violent intraday price changes. Thus, should a price of a financial instrument fall significantly during a single trading day, the national competent authority is handed powers to prohibit or restrict short selling in order to prevent a disorderly decline in the price of the financial instrument (Article 23(1)). A liquid share is determined to experience a significant fall in price when close-to-close return yields, 10 per cent or more. This applies to illiquid shares as well, provided the company is included in the main national equity index and is the underlying for a derivative contract traded in a trading venue. Otherwise a significant decrease in price is defined as 20 per cent or more for a share which price is €0.50 or higher, or the equivalent in the local currency. In all other cases, the daily decrease in value shall be 40 per cent or more to be considered significant. For sovereign and corporate bonds, increases of 7 and 10 per cent in the yield, respectively, are deemed to be significant drops in value (Article 23(2-3)). Quite interestingly, certain market conditions that would be later identified by the Regulation were already broadly taken into account in a public statement ESMA released on 11 August 2011. In it ESMA noted that the European financial markets had been very volatile in the preceding weeks and that the “developments have raised concerns for securities markets regulators across the European Union”. The following day Spain, France, Belgium and Italy prohibited short selling with several publicly traded financial and insurance companies. The bans were originally set to last either 15 days or until further notice. Belgium and France lifted the ban on 11 February 2012. France did not validate the decision, but Belgium pointed to the reduced market volatility. Greece had already banned short selling on 9 August 2011. The Greek regulator HCMC made the decision while taking into account the conditions prevailing in the Greek markets. After several extensions, the ban was eventually lifted on 15 July 2013. However, the regulatory bodies in mainland Europe were not the first ones to implicate a relationship between high volatility and short selling. On 19 September 2008, the Securities and Exchange Commission described the market conditions as a period of unusual and extraordinary market volatility, while it appeared that “unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation.” A day earlier the Financial Services Authority justified its ban by stating that the measurements would protect and stabilize the markets. The Chief Executive Hector Sants was quoted that “while we still regard short selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets”. In 2012, the Australian market authority ASIC remarked that, during the financial crisis, countries around the world took steps to strengthen their financial systems due to the widespread concern that short selling was contributing to market volatility and putting enough pressure on market confidence to be systematically relevant to the global financial system and economy.
EU toughens short-selling rules as markets are hit by the coronavirus. The European Union's market watchdog is ramping up surveillance of hedge funds and other short sellers that may be taking advantage of the market rout caused by the coronavirus outbreak. Temporary measures announced by the European Securities and Markets Authority on 16 March 2020 will force investors to reveal more information about their short-selling positions by halving the threshold for disclosures. The ESMA's new rules, which also apply to the UK under the post-Brexit transition period, mean any short-selling position that accounts for 0.1 percent or more of a company's outstanding shares must be announced to the market, compared with the previous threshold of 0.2 percent.
The measures, which come into force immediately and will last three months, have been prompted by severe stock market losses that have caused some of the biggest ever one-day falls for indexes such as the FTSE 100. The ESMA said the measures were precautionary and appropriate given that the severe stock market volatility posed a serious threat to market confidence in the EU as short selling can increase price swings and result in larger losses across financial markets. The temporary measures stop short of bans imposed during both the 2011 eurozone credit crisis and the 2008 global financial crash. In 2008, the UK's financial watchdog banned the shorting of 34 domestic stocks including major banks, asset managers and insurers for five months following the collapse of Lehman Brothers.
Application of the Short Selling Regulation (SSR) to the UK
When introduced, the SSR and the delegated regulations applied directly in the UK (and other EU member states) without the need for implementation in national law. Certain aspects of the SSR either afford discretion to national regulators or require those regulators to establish operational procedures to enable matters to be dealt with under national law. In the UK, these additional provisions were implemented by secondary legislation and changes to the UK Financial Conduct Authority (FCA) Handbook.
The UK withdrew from and ceased to be a member state of the EU on 31 January 2020. The negotiated withdrawal agreement entered into between the UK and the EU provides for a transition period, commencing on 31 January 2020 and ending on 31 December 2020, unless extended (such period, the “transition period”). The withdrawal agreement stipulates that EU law such as the SSR, shall apply to and in the UK during the transition period. The UK also intends to “onshore” the SSR into UK national law, with the UK version of the SSR applying after the end of the transition period.
The COVID-19 pandemic has resulted in extreme volatility in equity markets across the EU. In response, several market regulators across the EU have taken action, using powers under Article 20 of the SSR to temporarily ban short-selling in certain securities.
On 18 March 2020, the Austrian Financial Market Authority (FMA) issued a temporary prohibition on short sales of all shares that are admitted to trading on the Regulated Market of the Vienna Stock Exchange. The prohibition will stay in effect for an initial period of one month and started on 18 March 2020.
Belgium's Financial Services and Markets Authority (FSMA) announced the temporary prohibition for 17 March 2020, of the short-selling of the shares of 18 issuers admitted to trading on the Belgian Euronext market.
The Autorité des Marchés Financiers (AMF), the French financial regulator, issued a temporary prohibition on the short sales concerning the shares of 90 issuers on the Paris exchange, commencing on 17 March 2020.
The Hellenic Capital Markets Commission (HCMC) issued a temporary prohibition on short-selling of all shares admitted to trading on the regulated market of the Athens Stock Exchange. The measure came into force on 18 March 2020 and will last until 24 April 2020.
The temporary measure by the Commissione Nazionale per le Società e la Borsa (CONSOB), the Italian regulator, prohibits short selling applies to all the traded shares on the Italian regulated market, from 18 March 2020 until 18 June 2020.
The Comisión Nacional del Mercado de Valores (CNMV) has issued a temporary prohibition on short-selling of shares of equities admitted to trading on all Spanish trading venues (the Madrid, Barcelona, Valencia and Bilbao Exchanges, and the Mercado Alternativo Bursátil), lasting for an initial period of one month, from 17 March 2020 until 17 April 2020.
Under Article 27 of the SSR, within 24 hours of receiving a notification of a short-selling prohibition from a national regulator, ESMA is required to issue an opinion on whether it considers the measure, or proposed measure, necessary to address the exceptional circumstances identified by the national regulator. The ESMA has issued a positive opinion in respect of all of the prohibitions described above.
The UK Position
The FCA issued a statement (FCA Statement) on these short-selling prohibitions on 17 March 2020. The FCA noted that when considering whether to use its short-selling powers following action by another EU regulator, its standard policy has been to assist that regulator in enforcing the prohibition. The FCA further noted, however, that it has never used the relevant banning powers given to it under the SSR and that while it would not rule out such action in exceptional circumstances, it sets a high bar for imposing such a measure. On 23 March 2020, the FCA issued a further statement on short-selling, providing more detail on why it has not introduced a short-selling ban to date:
“The FCA continues closely to monitor market activity, including short-selling activity. Aggregate net short-selling activity reported to FCA is low as a percentage of total market activity and has decreased in recent days. It will continue to fluctuate, but there is no evidence that short selling has been the driver of recent market falls. A great many investment and risk management strategies rely on the ability to take 'long' and 'short' positions. These benefit a wide range of ordinary investors including the pension funds for employees of companies and local government. We also note that short selling is a critical underpinning of liquidity provision. The loss of these benefits would need to be carefully balanced before determining that any intervention to prevent short selling was appropriate.”
The new threshold reporting obligations apply to any natural or legal person, irrespective of their country of residence. They do not apply to shares admitted to trading on aEuropean Economic Area (EEA) or UK regulated market where the principal venue for the trading of the shares is located in a third country, or to market making or stabilization activities. The FCA Statement indicated that it will apply this temporary change to the reporting thresholds, but that this would involve changes to its systems. Until the FCA has made these changes, it has indicated that it expects firms providing reports in respect of UK listed shares to use the previous, 0.2 percent threshold.
There was widespread criticism of short sellers in the wake of the 2008 financial crisis, when certain investors were accused of deliberately undermining confidence in banking shares, fueling the global market instability. The regulator has had its hand strengthened by the continued critical voices around the world. Despite the already stringent rules, participants around the globe have been asking for further tightening. In June 2017, Tom Farley, head of the New York Stock Exchange, said that short sellers should be forced to reveal more of their activities and called the practice of short selling “icky and un-American.”
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