WIREDGOV

The purpose of the document being published is to consult market participants, regulators and other stakeholders on the options being considered by the Commission services for a forthcoming legislative proposal dealing with potential risks arising from short selling and Credit Default Swaps.

Short selling is the sale of a security that the seller does not own, with the intention of buying back an identical security at a later point in time in order to be able to deliver the security. Short selling can be divided into two types:

• 1."Covered" short selling is where the seller has borrowed the securities, or made arrangements to ensure they can be borrowed, before the short sale.

• 2."Naked" or "uncovered" short selling is where the seller has not borrowed the securities at the time of the short sale, or ensured they can be borrowed.

A Credit Default Swap (CDS) is a derivative which is sometimes regarded as a form of insurance against the risk of credit default of a corporate or government (or sovereign) bond. In return for an annual premium, the buyer of a CDS 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 default.

In addition to short selling on cash markets, a net short position can also be achieved by the use of derivatives, including Credit Default Swaps (CDS). For example, if an investor buys a CDS without being exposed to the credit risk of the underlying bond issuer (a so-called "naked CDS"), he is expecting, and potentially gaining from, rising credit risk. This is equivalent to short selling the underlying bond.

Why is the European Commission planning a legislative initiative in this area?

During the financial crisis and more recently in the context of market volatility in euro denominated sovereign bonds, Member States have reacted differently to short selling issues, with a variety of measures being put in place using different powers. A fragmented approach can limit the effectiveness of the measures imposed, lead to regulatory arbitrage (which basically means shopping around for the least onerous regime) and create additional costs and difficulties.

In the context of its ongoing review of the Market Abuse Directive, the Commission asked questions in April 2009 (IP/09/600) about the possibility of a new European short selling regime. The responses gave some support for a new regime. Many respondents argued however that any proposals should not be in the Market Abuse Directive but in separate stand-alone legislation. This was on the basis that it was generally considered that most short selling is not market abuse and raises different issues and risks.

In March 2010, the Committee of European Securities Regulators (CESR) published a report recommending a pan-European model for the disclosure of short positions in EU shares.

More recently, in the Commission Communication of 2 June 2010 on "Regulating Financial Services for Sustainable Growth" the Commission indicated that it would propose appropriate measures relating to short selling and credit default swaps.¹ This Communication also highlights other initiatives, such as legislation on market infrastructure, the review of the Markets in Financial Instruments Directive and the review of the Market Abuse Directive, which will also affect the regulatory framework applicable to derivatives and credit default swaps.

The Commission believes that working towards a more harmonised regime will increase the resilience and stability of financial markets in the European Union.

What would be the overall objectives of the initiative?

The intention is that the measures envisaged on short selling should:

• ensure Member States have the power to act to reduce systemic risks and risks to financial stability and market integrity arising from short selling and Credit Default Swaps,

• facilitate co-ordination between Member States and the European Securities Markets Authority (ESMA) in emergency situations;

• increase transparency on the short positions held by investors; and

• reduce settlement risks linked with uncovered or naked short selling.

What options are included in the consultation document?

The options envisaged can be grouped into three types:

• Powers for competent authorities to temporarily restrict or ban short selling and Credit Default Swaps in emergency situations (subject to coordination by ESMA);

• Measures to increase transparency to regulators and the market about short selling positions, including those obtained through the use of derivatives; and

• Measures to reduce settlement risks of uncovered or naked short selling.

The options under consideration also foresee powers for competent authorities to enforce the rules and the possibility of some limited exemptions (for market makers and shares whose principal market is outside the EU).

How would the policy options ensure greater transparency of short selling?

The consultation document sets out two different options for greater transparency of short positions held by investors.

The first option would be to apply the transparency regime to all types of financial instruments that are admitted to trading on a trading venue in the EU. The second option would be to apply the regime only to EU shares and to EU sovereign bonds. Both options would include not only short positions obtained by short selling the financial instrument itself but also positions obtained through the use of derivatives relating to the financial instrument.

The policy options relating to transparency are largely based on the two tier model for EU shares recommended by CESR (the Committee of European Securities Regulators) in its report in March 2010. The CESR model provides that at a lower threshold notification of a short position should be made only to the regulator and at a higher threshold short positions should be disclosed to the market. Notification to regulators would enable them to monitor and, if necessary, investigate short selling that may pose systemic risks or be abusive. Publication of information to the market would provide useful information to other market users.

Under the second option, there would be a specific regime for notification to regulators only of significant net short positions in EU sovereign bonds. Disclosure to regulators of significant net short positions relating to EU sovereign bonds could provide important information to assist regulators to monitor whether such positions are creating disorderly markets or systemic risks or are being used for abusive purposes.

The option on sovereign bonds contemplates that information should be disclosed only to regulators rather than to the market as the effect of public disclosure on the operation of sovereign bond markets still needs to be assessed.

Does the consultation include policy options to restrict "naked" or uncovered short selling?

Naked or uncovered short selling of securities is a short sale where at the time of the sale the securities have not been borrowed or adequate arrangements have not been made to ensure that they can be borrowed. It is sometimes argued that naked short selling can increase the risks of settlement failure and result in increased price volatility.

The consultation includes a number of options aimed at reducing these potential risks:

• The first option would be to place conditions on uncovered short selling so that at the time of the sale the seller must either have borrowed the share, have entered into an agreement to borrow the share or have evidence of other arrangements which ensure that it will be able to borrow the shares at the time of settlement

• The second option would be to require trading venues to have in place measures for the buying in of shares in certain situations if a short sale results in a settlement failure.

It should be noted that naked short selling in its usually understood sense relates to shares. However, recently, national decisions have also been taken regarding sovereign bonds. The expression "uncovered" or "naked" in the context of credit default swap transactions is a different concept that raises different issues (see the explanation and discussion below).

What emergency powers are envisaged for competent authorities?

The options in the consultation document would provide for competent authorities to be given powers to impose temporary restrictions on short selling and CDS transactions in an emergency. The options attempt to harmonise the conditions under which emergency action may be taken, the procedures for taking action and the scope of powers themselves (while still allowing flexibility in emergency situations).

As the need for close consultation and co-ordination between competent authorities is essential where an emergency has cross border implications, the new European Securities Market Authority (ESMA) could perform a key coordination and facilitation role.

Also it is important to note that actions taken under the present options would be intended to be temporary in nature and only for emergency situations.

These powers would enable competent authorities to take the type of emergency action taken by a number of Member States in recent months. Competent authorities would then need to clearly justify why they are taking action, this could only be for a limited period of time and would be subject to various processes and coordination by ESMA.

Does the consultation envisage a ban on so called "naked CDS"?

A "naked CDS" refers to the situation where the CDS is used by the buyer not to hedge a risk but to take a position (take risk). The seller of the CDS would gain if the credit risk did not materialise; whereas the buyer of the CDS would gain if the price of the CDS subsequently increases due to a perception by the market of an increased risk of default of the issuer.

The options in the consultation foresee:

• Greater transparency so that persons with significant net short positions in sovereign bonds would have to notify regulators of their positions. This would include such positions obtained through the use of CDS. This would enable regulators to monitor whether such positions are creating disorderly markets or systemic risks or being used for abusive purposes.

• Powers for regulators to obtain information in individual cases about CDS transactions.

• Powers in an emergency for a competent authority to temporarily prohibit or restrict the use of CDS. Such emergency measures would be temporary in nature and subject to coordination by ESMA.

Are any exemptions discussed?

Limited exemptions are discussed in the consultation document, notably for market making, which is important to the efficiency of markets and where the requirements could severely inhibit their ability to provide liquidity to European markets. The consultation document also asks whether any exemption is needed for shares whose principal market is outside the European Union and whether any other special rules are needed with regard to operators or markets outside the European Union.

When does the consultation end and what is the proposed timing for adoption of a legislative proposal?

This consultation is open until 10th July 2010. The responses to this consultation will provide important guidance to the Commission services to prepare a Commission proposal, which is currently scheduled for adoption by the end of the summer.