Spain short selling
December 2008 International Financial Law Review
Why Spain suffered less from short selling
Aggressive forms of short selling have recently been blamed as one of the principal reasons for the collapse of Lehman Brothers and with it the subsequent convulsion and extreme volatility of the financial markets. Spain has suffered little from this problem, in part because of a particular approach to settlement.
Shorting v naked shorting
Short selling is generally seen in Spain as a type of speculative transaction whereby a seller is permitted to bet on the downward movement of the share price of a company and therefore adopt a negative position on it. Otherwise, in a non-speculative environment, in Spain shorting trades are seen as defensive transactions in order to hedge long positions (which are expected to rise) and thus ensure partial coverage if there is an undesired drop in the share price.
In Spain, short selling is permitted to the extent that before entering into a trade the seller has specified share availability to make the relevant disposal, be it by virtue of a securities loan, the execution of a conversion or option right, the settlement of a derivative or otherwise.
Naked short selling, which implies the sale of shares without first arranging a borrowing scheme, is not allowed in Spain. One of the big risks of a naked shorting transaction is that the short seller may not be able to deliver the shares at the pre-determined date for clearing and settlement of the trade (generally, T+3). These trades, which are not cleared on the established settlement date, are considered as failed-to-deliver. Nevertheless, provided that there is liquidity in the market, the naked short seller would generally comply with its obligations to deliver the shares on or before the settlement date. For that reason, it is sometimes difficult to detect the existence of naked shorting. However, shorting the shares without actually borrowing makes the possibility of driving down the share price of a company much more feasible: the damage can be done even though the short seller finally manages to deliver the shares on the settlement date.
The regulator’s reaction
Amid the turmoil and following the many claims against short selling practices, market regulators in many jurisdictions (notably led by the Securities and Exchange Commission in the US and the Financial Services Authority in the UK) have introduced rules aimed at reducing the possibility of using short selling structures against vulnerable companies in a complex and turbulent market. The common denominator is the restriction and, in many cases, the total prohibition of naked shorting.
Driven by this international trend, the Spanish regulator, the Comisión Nacional del Mercado de Valores (CNMV) passed (with effect from September 24 2008) a number of measures aimed at controlling big short-selling transactions (the Resolution). However, unlike those of many other countries, the applicable Spanish regulations already provided good protection against naked short selling.
In Spain, naked short selling transactions have been prohibited since 1939. Thereafter, Article 64 of Royal Decree 1506 of June 30 1967 approving the stock exchanges, which is still in force, specifically prevents the possibility of trading shares not previously owned. In view of this, the measures introduced by the Resolution only serve to remind us of the existence and full applicability of the regulations.
It has already been mentioned that short-selling practices introduce the general (and well-founded) fear for some foreign regulators that short trades may not be settled on time and will therefore be considered as failed-to-deliver. This risk is substantially increased in periods of market turbulence and short liquidity, even more so where naked shorting practices are permitted. This problem has traditionally been alien to Spain.
First, this is because naked shorting transactions are forbidden. Second, it is because, contrary to most EU countries, the settlement of (normal, permitted shorting) sales under the Spanish variable income (equity) trading system requires the previous identification by the selling member of the securities that are intended to be sold. This is effectively implemented and evidenced with the registry references (RRs), which specifically identify the transferring securities.
The RR is the essential control mechanism of the Spanish system of registry and cancellation for securities ownership, which is run by Iberclear in conjunction with the participating entities. They identify a number of homogeneous securities owned by a holder that, upon acquisition, are recorded with Iberclear as a single transaction. Therefore, RRs allow for the individual identification of all the securities and the transactions through which a holder acquires them.
In practice, in order to ensure that there are enough securities to cover a trade (and thus avoid failures to deliver), credits or debits from Iberclear to the securities accounts during the clearing and settlement process are dependent upon the issuance and cancellation of the RRs of the relevant securities that are being traded. This mechanism enables the system to ensure that in permitted shorting transactions the seller has the capacity to dispose of the securities and that it will deliver on the settlement date.
Accordingly, the settlement of purchases on the Spanish market simply requires that the buyer of the securities delivers the relevant cash amount. In turn, the stock market and Iberclear will issue and assign to the buyer the relevant RRs for the securities acquired. The settlement of sales is rather more complex. It requires the identification by the selling member of the existence of the RRs that identify the existence of the securities and the registration of them in favour of the seller at the time they are being traded (before they are cancelled). Therefore, trades are not settled against a general balance of RRs or an unspecified RR. This is substantially different from the clearing and settlement systems of many EU countries whereby, following a balance system, trades are conditional only upon the seller holding a sufficient balance of the securities that are being sold (without specifically identifying them before settling the trade).
The appropriateness of modifying the complexities and requirements of the Spanish post-trading system has been discussed al length. However, the reality has thus far proven (particularly with regard to shorting transactions in situations of extreme market volatility) that these mechanisms ensure completion of trades according to the highest standards, reducing failures to deliver on the settlement dates to a bare minimum.
In these latter cases, there is an additional guarantee mechanism in Spain to ensure that trades are made on time. That is, if a participant does not deliver the securities on the settlement date, Iberclear resorts to an automatic securities lending scheme entered into with certain members with the aim of delivering the loaned securities to the purchasing entity on the settlement date without delay. These failed sales would have an extra term of one working day for the defaulting (non-delivering) party to evidence and settle. Should this grace period elapse without compliance, Iberclear will buy the same amount of securities on behalf of the defaulting participant. Those securities would be used to return the loan. The cash for the original sale by the defaulting party would be used to pay for the replacement securities. This is the case notwithstanding the penalties that Iberclear may impose on the defaulting party, as well as the assumption by the latter of any potential losses deriving from the pricing of the securities.
Following the criteria of other regulators, the CNMV has taken advantage of the international focus on short selling practices to introduce a new reporting requirement for permitted short positions held in a specific number of financial issuers that are deemed by the CNMV to be particularly exposed to the crisis (mainly banks and savings banks).
In particular, the Resolution imposes the obligation to disclose the short position held in the share capital of exposed companies whenever it exceeds 0.25% of their share capital admitted to trading. To this end, the CNMV has clarified that a short position is the net result of all the positions held in financial instruments (including the owned shares of the protected issuer and those indirectly held via participative bonds and derivatives instruments of which the underlying assets are the shares) that provides the holder a positive exposure in the event of a downward movement of the price of the shares over which the reporting is being made. The Resolution extends the reporting obligation to any subsequent increase or decrease over the threshold position of 0.25%.
The disclosure of net short positions must be carried out by means of a material fact (hecho relevante), which must be submitted before 7:00pm on the day following the triggering of the reportable position. Failure to notify the net short positions will be deemed by the CNMV as a token action that may lead to market abuse in the sense of distorting the free movement of share prices. However, the CNMV has expressly recognised that, when monitoring these new rules, it will take into account the operative needs of those entities that usually operate as market makers or those that provide liquidity to the market.
Reporting obligations will remain in force for an indefinite period of time until the market conditions that forced their application improve, at the discretion of the CNMV.