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Trade in securities: Commission adopts technical standards for “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 is a technique used by investors who think that the price of an asset, e.g. shares or oil contract, fill fall. They borrow the asset from another investor and then sell it in the relevant market. The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference.
There are two types of short selling: a) so-called "covered" short selling (where the seller has borrowed the securities before the short sale) and b) “naked" or "uncovered" short selling (where the seller has not borrowed the securities at the time of the short sale but ensured that they can be borrowed). The technical standards of 29.06.2012 are designed to ensure that any short selling that takes place on the EU's financial markets is "covered".
The technical standards adopted at the end of June by the Commission are based on the work of the European Securities and Markets Authority (ESMA). They notably specify the details of the so-called "locate rule," which ensures that short sales do not result in a failure to deliver. The new rules also detail how ESMA is to determine the shares which are exempt from the Short Selling Regulation* by virtue of their principal trading venue being outside the Union. Together with the Short Selling Regulation that they implement, the new regulations will create a more transparent, orderly and stable market by reducing the risks tied to short selling.
Internal Market and Services Commissioner Michel Barnier said: "The new rules give public authorities and market participants legal certainty on the detailed requirements which short sellers must comply with to adequately ensure the settlement of shares or sovereign debt when this is due. The technical requirements on how to disclose significant short positions are also set out, so that market participants can prepare to apply the Short Selling Regulation as of 1 November 2012."
Reference: Press Release, IP/12/727, 29 June 2012.
The Implementing Regulation describes the technical rules on the following issues to ensure the consistent application of the Short Selling Regulation:
- Information on significant net short positions shall be disclosed on a central web site operated or supervised by the relevant competent authority in a specified format, which allows the public to search the information by share issuer and to see historical data;
- The requirements for agreements to borrow (such as options, repurchase agreements, or standing agreements) that ensure settlement of shares can be effected when due;
- The requirements for arrangements and measures to ensure settlement in due time of short sales of shares; for standard locate arrangements, this includes two confirmations by a third party: firstly, that the party can make the shares available, and secondly; that it has at least put the requested number of shares on hold prior to the short sale; specific arrangements are set out for intra-day short selling and for shares which are easy to borrow or purchase;
- The details of arrangements with third parties relating to short sales of sovereign debt to ensure a reasonable expectation that settlement of the sovereign debt can be effected when due;
- The types of third parties, including investment firms and central counterparties, and the requirements they must meet to be eligible to enter into arrangements with short sellers to ensure settlement;
- The format for the periodic information on net short positions to be provided to ESMA by competent authorities; and
- The technical rules for ESMA to determine whether the principal trading venue of a share is inside or outside the European Union and subsequently implement the exemption in the Short Selling Regulation for shares whose principal trading venue is outside the Union.
The Implementing Regulation is part of a package of four implementing measures that the Commission will adopt to specify technical aspects of the Short Selling Regulation. A Delegated Regulation on regulatory technical standards was also adopted by the Commission at the end of June 2012, based on draft regulatory technical standards submitted by ESMA. This sets out the details of the information on short positions that must be notified to competent authorities and disclosed to the public. It also specifies what information competent authorities must report on a quarterly basis to ESMA, and the method of calculation of turnover for ESMA to determine the principal trading venue of shares.
The Implementing Regulation will enter into force on the day following its publication in the Official Journal of the European Union and shall apply from 1 November 2012, except for the provisions on the principal trading venue, which shall apply from the date of entry into force.
The Delegated Regulation on regulatory technical standards is subject to a one-month objection period by the European Parliament and the Council, which can be extended by one month, and will only enter into force, provided that neither co-legislator objects, at the end of this period and the day following publication in the Official Journal.
In order to fully implement the Short Selling Regulation, two final measures – a Regulatory Technical Standard and a Delegated Act – are expected to be adopted shortly.
Further information: See also MEMO/12/508;
Short Selling Regulation and text of the Implementing Regulation on:
The Commission published (Brussels, 29 June 2012, MEMO/12/508) the answers to most frequently asked questions on technical standards in short selling issues. Some of the most important are shown below.
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.
The technical standards of 29.06.2012 are designed to ensure that any short selling that takes place on the EU's financial markets is "covered".
Short selling risks
Concerns have been raised that naked short selling brings with it an increased risk of settlement failure, and that at a time of considerable financial instability, short selling could aggravate falling share prices, notably in financial institutions, in a way which could ultimately threaten their viability and create systemic risks. At the height of the financial crisis in autumn 2008, competent authorities in the United States and several EU member states adopted exceptional measures to restrict or ban short selling in some or all shares. The measures adopted by the EU member states were divergent, since the Union lacked a specific legislative framework for dealing with short selling issues at the time in order to mitigate these risks, while allowing the practice of short selling. Such a framework is provided in the Regulation on Short Selling and Credit Default Swaps (see Regulation (EU) 236/2012), which entered into force on 25 March 2012 and will apply from 1 November 2012. The technical standards that the Commission has adopted in June are the practical measures linked to this Regulation.
Current short selling legislation in the EU
According to Regulation (EU) No 236/2012, short selling of shares can only happen if sellers either have borrowed the shares, have a binding agreement to borrow the shares, or have an arrangement with a third party that means they can reasonably expect to deliver the shares they are selling.
The technical standards adopted in June 2012 set out the technical details of how this Regulation will apply in practice, notably the types of agreements, arrangements and measures that adequately ensure that the shares sold short are available for settlement; they will apply from 1 November 2012.
Reference: Press Release, MEMO/12/508, 29 June 2012
Restrictions provided in the Short Selling Regulation
To reduce the risks of settlement failures and increased price volatility that can be associated with naked short selling of shares and sovereign debt, certain requirements are introduced. There are distinct restrictions for shares and for sovereign debt.
For shares: In order to enter a short sale, an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party under which that third party has confirmed that the share has been located and has taken measures vis-à-vis third parties necessary for the investor to have reasonable expectation that settlement can be effected when it is due (the procedure is known as a 'locate rule').
ESMA shall develop a draft implementing technical standards to determine the types of agreements, arrangements and measures that adequately ensure that the share will be available for settlement. For sovereign debt: In order to enter a short sale an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party under which that third party has confirmed that the share has been located or has otherwise reasonable expectation that settlement can be effected when it is due. The restrictions do not apply if the transaction serves to hedge a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the given sovereign debt. In addition, the competent authority may temporarily (for 6 months, renewable) suspend these restrictions where the liquidity of the sovereign debt falls below a pre-determined threshold, to be set by the Commission in a delegated act. ESMA shall develop a draft implementing technical standards to determine the types of agreements, arrangements and measures that adequately ensure that the sovereign debt will be available for settlement.
Technical standards for short selling
The technical standards adopted in June 2012 lay out in detail:
- the different types of agreements, arrangements and measures that adequately ensure that the shares sold short are available for settlement;
- the functioning of the "locate rule" for shares and sovereign debt;
- the mechanisms of information disclosure, to increase transparency in short selling;
- requirements on the types of third parties that can be involved in short selling; and
- the method for determining which shares have a principal trading venue outside the EU and are therefore outside the scope of the Short Selling Regulation.
Different agreements for short selling of shares and sovereign debt
The types of agreements are:
- futures and swaps;
- repurchase agreements;
- standing agreements or rolling facilities;
- agreements relating to subscription rights; and
- other claims or agreements that lead to the delivery of shares or sovereign debt for the purposes of short selling.
All these types of agreements must cover at least the number of shares or the amount of sovereign debt being sold short, must be entered into prior to or at the same time as the short sale and must specify a delivery or expiration date that ensures settlement of the short sale can be effected when due. These agreements must exist in a "durable medium", whether in electronic or paper form, and are legally binding for the duration of the short sale.
The meaning of "locate rule"
The "locate rule" is a term used to describe the arrangement whereby a broker confirms to a short seller that they have located the shares which the short seller needs to borrow to cover their short sale, taking into account the amount required and market conditions. It is thanks to this arrangement and the subsequent measures to be taken vis-à-vis third parties that the short seller is able to have the reasonable expectation that he can deliver the shares he is short selling. The locate rule is an essential part of EU law on short selling: without location of the shares to be sold short, and the subsequent measures vis-à-vis third parties, short selling of shares is not permissible.
There are three different ways that the locate rule can work which are detailed in the technical standards:
= The broker confirms he has located the shares to be sold, and he at least puts them on hold. This is the standard functioning of the locate rule.
In the case of short selling that is to take place within the same day, known as intraday short-selling, the short seller needs first to inform the broker that this is his intention.
= The broker then confirms he has located the shares to be sold. The broker then has to either confirm that the share is easy to borrow or purchase, or if not that he has at least put the required amount of shares on hold. The short seller must monitor the market, and if he finds he risks not being able to deliver, he must then give an instruction to the broker to buy the shares needed to cover his short sale.
= In the case of liquid shares, the broker confirms he has located the shares to be sold, and that either the shares are easy to borrow or purchase in the required amount, or that he has at least put them on hold. The short seller gives the broker a commitment that he will give him an instruction to buy or borrow the shares needed to cover his short sale if it transpires that he is not able to buy them in the market.
All of these variants of the locate rule build on existing market practice and on the regulatory framework in the United States.
The broker, or third party used to locate shares, must be a legally separate entity from the seller. It cannot for example be the internal lending desk of the same investment firm. The technical standards also set out the types of third party that can provide locate confirmations, and the requirements they have to fulfill. These are: participating in the management of borrowing or purchasing of the shares or sovereign debt; providing evidence of such participation; and being able to provide on request evidence of their ability to deliver, including statistical evidence.
Uncovering short selling of sovereign debt
The requirements for uncovered short selling of sovereign debt in the Short Selling Regulation are different than those for shares, to reflect the specificities of the sovereign debt markets. The key difference is that unlike for shares, for sovereign debt there is no requirement on the third party to put the sovereign debt on hold. According to the technical standards, for short sales of sovereign debt there are four different kinds of arrangements that make short selling permissible:
= A third party (broker) must confirm that the sovereign debt has been located, that is to say that it considers that it can make the sovereign debt available for settlement in due time;
= In the case of intra-day short selling of sovereign debt, the short seller has to confirm to the broker that this is his intention; the third party (broker) then confirms to the short seller that it has a reasonable expectation that the sovereign debt can be purchased in the relevant quantity, taking into account the market conditions and other information available to it.
= The short seller goes through a third party which participates in a structured arrangement, such as one organised by a central bank, that gives it unconditional access to the sovereign debt to be sold short in the amount required for settlement, and can therefore confirm that it has a reasonable expectation that settlement will take place when due.
= A third party (broker) confirms that the sovereign debt being sold short is easy to purchase in the relevant quantity taking into account market conditions.
Effect for sovereign debt management of countries' budget deficits
The restrictions on uncovered short selling of sovereign debt are lighter than those required for shares. This is because they have been tailored for sovereign debt. Therefore, these new technical standards should not affect the management of countries' budget deficits.
Furthermore, a safeguard is in place in the Short Selling Regulation: if a country finds that its sovereign debt market is being impaired by these restrictions – if there is a significant decline in the liquidity of the sovereign debt – then it can suspend these standards for six months, as long as liquidity has fallen below a threshold set by the Commission in a delegated act. This delegated act is due to be adopted shortly by the Commission as required by the Short Selling Regulation.
Technical rules on information disclosure
In order to improve transparency of short selling, the Short Selling Regulation requires information on significant short sales of shares and sovereign debt to be notified to the regulator, once a reporting threshold has been crossed. For shares, the threshold represents a short position of 0.2% or more of that company's share capital. For sovereign debt, the thresholds are to be set by the Commission in the delegated act to be adopted shortly. For shares only, if the short position represents 0.5% or more of the issued share capital, information on the sale needs to be disclosed to the public.
New technical standards require that information on significant short positions in shares disclosed to the public must be disclosed on a central web site operated or supervised by the regulator, in a machine-readable format so that the public can search the web site for information by issuer and access historical data.
Measures on dual traded shares inside and outside the EU
In the case of shares traded both within and outside the EU, the Short Selling Regulation requires ESMA to determine the shares' principal trading venue, and this will determine whether the shares are subject to the Short Selling Regulation; if the principal trading venue is outside the EU, these measures will not apply. ESMA is also required to regularly publish a list of exempted dual-traded shares. New technical standards set out the process for ESMA to determine what the principal trading venue for dual-listed shares is.