4.2. Powers of ESMA
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This newsletter summarises the new European legal framework regarding the undertaking of net short positions in shares and sovereign debt, uncovered positions in sovereign credit default swaps and uncovered short selling of the first two types of securities.
The new regulation is introduced to resolve discrepancies between the resolutions adopted by the regulatory authorities of the Member States and third countries since September 2008 regarding the restriction or prohibition of short selling of some or all securities admitted to trading on the secondary markets of their respective jurisdictions.
In view of this situation, the EU recently approved a set of regulations on the transparency requirements and powers of domestic regulatory authorities for short selling and sovereign credit default swaps, to establish a common regulatory framework and to ensure a more coordinated and consistent approach by Member States when measures need to be adopted to deal with extraordinary circumstances.
The new regulatory framework is based on Regulation (EU) No. 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps, which, since its approval, has been supplemented by several delegated regulations regulating technical aspects necessary for its effective enforceability and to ensure compliance with its provision, as well as by related implementation documents prepared by the European Securities and Markets Authority (ESMA)[1].
The new EU regulation intends to mainly regulate: (a) the notification obligations (and exemptions) of net short positions in (i) shares and other financial instruments linked to the issued share capital which principal trading venue, in terms of turnover, is located in the EU and (ii) sovereign debt securities issued by Member States or by the EU; and (b) the prohibition of uncovered (naked) short selling of shares and sovereign debt. Therefore, the obligations/prohibitions described in this newsletter will apply regardless of the holder’s nationality and of where the transactions are executed.
This new European regulation will apply from 1 November 2012.
1. TRANSPARENCY OF NET SHORT POSITIONS
Net short positions in shares and sovereign debt securities[2] can be communicated through two different notification systems.
1.1. Notification of net short positions in shares
A two-tier notification system (private notification and public disclosure) is established. The appropriate system depends on the threshold reached by the net short position:
- Private notification: Net short positions in shares equal to or less than 0.2% of the share capital of the issuer and subsequent increases and decreases of 0.1% must be notified to the competent authority of the market on which the shares are traded (or to the regulator of the most relevant market in terms of liquidity, if listed in several Member States).
- Public disclosure: Details of any net short position equal to or less than 0.5% of the share capital, as well as subsequent increases and decreases of 0.1%, must be publicly disclosed.
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1.2 Notification of significant net short positions in sovereign debt and uncovered positions in sovereign credit default swaps
The reason for the obligation to notify significant net short positions in sovereign debt is to provide regulators with information that enables them to control whether these positions are generating systemic risks or being used for abusive purposes.
In contrast with the abovementioned regulation, these notifications must be provided to regulators by means of a private communication. This different approach is justified on the potential negative effects that disclosure could have on the already depleted liquidity of sovereign credit markets.
The notification thresholds are 0.5% or 0.1% of the outstanding issued sovereign debt, depending on whether or not it exceeds €500 billion[3].
This procedure will also apply to the notification of uncovered positions in sovereign credit default swaps when the restrictions on these transactions are lifted by the regulator of the relevant Member State (see section 2).
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1.3. Notification and disclosure procedures
Notifications must be made by 15.30h (local time) of the trading day following the day when the relevant threshold was reached, exceeded or fallen below.
As this new legal regime will apply from 1 November 2012, the first notification must be made by 15.30h of 2 November 2012, except in jurisdictions where 1 November is not a trading day, in which case it must be made by the second trading day after 1 November 2012[4].
Notification is mandatory even if the same position has been already notified to the domestic regulator in compliance with transparency obligations previously in force in that jurisdiction[5].
The information to be disclosed is set out in Table 1 of Annex I of Delegated Regulation 826/2012, according to the format approved as Annex II of this Regulation. The information will be published, where appropriate, in a webpage operated or supervised by the corresponding authority.
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2. NAKED short SELLING PROHIBITION
The second set of changes relates to the prohibition of naked short selling (the sale of securities that the seller does not hold or which availability it cannot guarantee[6]), given that these transactions increase the potential risk of settlement failure and market volatility.
This prohibition applies to naked short selling of shares[7] and sovereign debt (regardless of the currency in which they are issued), without prejudice to the exemptions described in section 3.
In this regard, in order to short sell shares or sovereign debt: (i) the securities must be borrowed in advance (or by means of an alternative arrangement with similar legal effects); or (ii) there must be an agreement allowing the seller to borrow the securities (or any other arrangement affording the right to acquire them); or (iii) there must be an agreement with a third party under which the latter confirms that the security has been located and will be available on the settlement date (e.g., futures, swaps, call options, repurchase agreements, pre-emptive subscription rights).
Naked short selling of sovereign debt is allowed if used to hedge a long position, provided that there is a high degree of correlation between its trading price and the trading price of the sovereign debt, and the liquidity of the sovereign debt falls below the minimum threshold[8].
Finally, transactions involving uncovered sovereign credit default swaps are prohibited, although each Member State may temporarily lift this prohibition when it has objective grounds (based on specific indicators) that these restrictions may increase the cost of borrowing for sovereign issuers or affect the sovereign issuers’ ability to issue new debt.
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3. exemptions
3.1. Where the principal trading venue is in a third country
The obligation to notify and the prohibition to carry out naked short selling of shares as described above will not be applicable if the principal trading venue is located in a non-EU Member State.
The principal trading venue will be determined by the regulatory authorities of the Member State where the shares are traded, depending on their respective turnover[9].
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3.2. Market making and stabilisation activities and primary market operations[10]
The obligations, restrictions, and prohibitions described in sections 1 and 2 (whether related to shares, sovereign debt or CDS) will not apply to market making activities (market makers –investment firms and credit institutions– intending to make use of this exemption will have to notify the competent authority of the relevant Member State not less than 30 calendar days before it first intends to make use of it [11]).
This exemption is based on the benefits of market making activities, which require taking uncovered short positions. Restricting this possibility would hinder the ability of market makers to provide liquidity, having an adverse effect on the efficiency of EU secondary markets.
Stabilisation practices carried out in accordance with Regulation (EC) 2273/2003 are also exempt (except for the obligation to notify net short positions in sovereign debt).
Primary dealers authorised through an agreement with a sovereign issuer will not be required to notify their short positions in sovereign debt and may short sell naked sovereign debt and carry out transactions on uncovered sovereign CDS.
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4. intervention powers of regulatory authorities of member states and of ESMA
4.1. Powers of regulatory authorities of Member States
Where the competent authority of a Member State considers that (i) there are adverse events or developments that constitute a serious threat to financial stability or to market confidence (serious financial, monetary or budgetary problems, which may lead to financial instability, unusual volatility causing significant downward spirals in any financial instrument, etc.); and (ii) the measure is necessary and will not be disproportionately detrimental to the efficiency of financial markets in view of the advantages sought, the following measures may be adopted:
· Additional notification obligations
(a) modification of the thresholds for the notification of net short positions in relation to one or several specific financial instruments; and/or
(b) request the parties involved in the lending of a specific financial instrument to notify any change in the fees requested for such lending.
· Restrictions on short selling (or similar) and sovereign CDS transactions
(a) prohibit/impose conditions on short selling (or similar transactions that confer a financial advantage on the holder in the event of a decrease in the price of the security[12]); and/or
(b) restrict the ability to enter into, or limit the value of, sovereign CDS.
Where the price of a financial instrument has fallen significantly during a single day in relation to the closing price on the previous trading day (10% or more in the case of a liquid share), the competent authority may prohibit or restrict short selling of financial instruments for a period not exceeding the end of the trading day following the trading day on which the fall in price occurs.
Finally, broad supervisory and intervention powers are granted, such as the possibility of accessing any document, requiring information from any person, carrying out on-site inspections and requesting existing telephone and data traffic records.
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4.2. Powers of ESMA
ESMA’s role will mainly be to control and coordinate the measures adopted by the different Member States (for instance, to issue a non-binding opinion on the exceptional measures that the regulator of the relevant Member State intends to implement), but will also have intervention powers in exceptional circumstances, such as to require notification of net short positions or to prohibit short selling (or transactions with similar effects), when the purpose of these measures is to deal with a threat affecting several countries and these countries have not taken adequate measures.
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5. ENTRY INTO FORCE AND APPLICATION
The new common regulatory framework will apply from 1 November 2012. Therefore, the first notification of net short positions must be made by 15:30h (local time) of 2 November 2012.
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[1] Delegated Regulation 826/2012, Implementing Regulation 827/2012, Delegated Regulation 918/2012 and Delegated Regulation 919/2012, and the documents prepared by ESMA entitled ”Commission Delegated Regulation on Short Selling and Credit Default Swaps - Frequently asked questions”, of 5 July 2012 and “Questions and Answers – Implementation of the Regulation on short selling and certain aspects of credit default swaps”, of 13 September 2012 (updated on 10 October). All EU legislation and related documents are available at: http://ec.europa.eu/internal_market/securities/short_selling_en.htm
[2] For the purposes of calculating net short positions, whether payments are made as cash settlements or by physically delivering the underlying assets is irrelevant; and positions on financial instruments that give rise to a right over unissued shares (pre-emptive subscription rights, convertible bonds, etc.) need not be taken into account. Likewise, shares in funds that are managed on a discretionary basis will not be taken into account by the holder but rather by the corresponding fund or management entity, as the case may be; neither will dividends received in the form of shares that must be returned by a borrower to the lender as a result of a lending agreement.
[3] The notification thresholds for each Member State were published in ESMA’s website on 11 October 2012. The complete list is available at: http://www.esma.europa.eu/news/ESMA-publishes-notification-thresholds-sovereign-issuers?t=326&o=home
[4] 1 November 2012 is a trading day in Spain.
[5] Answer to “Question 1c” of the document prepared by ESMA, “Questions and Answers – Implementation of the Regulation on short selling and certain aspects of credit default swaps”.
[6] These restrictions do not alter the regulation already in force in Spain, since naked short selling of shares is forbidden according to article 64 of the Stock Exchange Regulation of 1967.
[7] This prohibition does not apply to transactions over securities including a right to subscribe new shares (e.g., convertible bonds and pre-emptive subscription rights), which can also be used to hedge short positions, provided that the new shares are available on the settlement date.
[8] When a monthly turnover falls below the fifth percentile of the monthly volume traded in the previous twelve months, each Member State‘s regulator may temporarily suspend the restrictions on uncovered short selling of sovereign debt for a maximum of 6 months (extendable).
[9] The calculation will be valid for 2 years, except where it needs to be recalculated due to unexpected circumstances (delisting from one of the venues or admission to trading of shares previously listed in a third country on an EU venue). The list of exempted shares is available at: http://www.esma.europa.eu/page/List-exempted-shares
[10] ESMA has yet to publish the final version of its “Exemption for market making activities and primary market operations under the Short Selling Regulation” dated 17 September, that will develop technical matters about the implementation of this exemption, which consultation period ended on 5 October 2012.
[11] To extend this exemption to third-country entities, the Commission will decide whether the third-country’s legal and supervisory frameworks are consistent with EU regulations on financial instruments, transparency and market manipulation (Directive 2004/39/EC, 2003/6/EC and 2004/109/EC). To date, the Commission has not issued a decision in this regard.
[12] A CNMV prohibition dated 23 July 2012 is currently in force in Spain banning transactions that may constitute or increase a net short position over stock admitted to trading. This prohibition was initially applicable until 23 October 2012, but it has been extended until 31 October 2012 through a CNMV decision dated 19 October 2012. The relevant procedure with the ESMA has also been initiated to keep the measure in force for an additional period of 3 months (until 31
January 2013).
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