EU Unveils Short-Selling and OTC Derivative Rules

by Ulrika Lomas, for LawAndTax-News.com, Brussels

20 September 2010

The European Commission (EC) has adopted proposals for the regulation of short selling and the reporting and clearance of over-the-counter (OTC) derivatives, to create a harmonized framework for coordinated action at the European level.

It was explained that ‘short selling’ is the sale of a security the seller does not own with the intention of buying it back later in order to deliver it, while ‘naked short selling’ is where the seller has not borrowed the securities, or ensured they can be borrowed before settlement, prior to the short sale. It has been blamed for specific risks of settlement failure and, since the onset of the financial crisis, many European Union (EU) member states have taken actions to suspend or ban short-selling.

It was further pointed out that, at present, there is little reliable information available on short selling, and it is difficult for market participants and regulators to know which securities are being traded ‘short’ and their overall significance. The EC’s proposal enhances transparency by requiring that all share orders on trading venues be marked as 'short' if they involve a short sale.

In addition, investors will now have to disclose significant net short positions in shares to regulators at one threshold (0.2% of issued share capital), and to the market at a higher threshold (0.5%). These measures will mean market participants are better informed whilst allowing regulators to monitor markets and detect developing risk.

With regard to sovereign bonds, regulators will be better able to detect possible risks to the stability of sovereign debt markets by receiving data on short positions, including those obtained through sovereign credit default swaps.

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 to locate and reserve them for lending so that they are delivered by the settlement date. Trading venues must ensure that there are adequate arrangements in place for the buy-in of shares or sovereign debt, as well as fines and a ban on short selling, where there is a settlement failure.

Furthermore, the proposal gives national regulators clear powers in exceptional situations to temporarily restrict or ban short selling in any financial instrument, subject to coordination by the new regulatory body, the European Securities and Markets Authority (ESMA), which should be operational from January 2011.

ESMA is also to be given the power to issue opinions to competent authorities when they intervene in exceptional situations. In line with the new supervision framework, ESMA will have the possibility, when certain conditions are fulfilled, to adopt temporary measures itself, with direct effect, restricting or prohibiting short selling.

If the price of a financial instrument falls by a significant amount in a day, national regulators will have the power to restrict short selling in that instrument until the end of the next trading day. These measures will help regulators take the necessary action, in a coordinated way, to slow or halt price declines which can be amplified by short selling in distressed markets.

The proposal now passes to the European Parliament and the European Council for negotiation and adoption. If adopted, the regulation would apply from July 1, 2012.

The Internal Market and Services Commissioner, Michel Barnier, said that the EC’s proposal “will increase transparency for regulators and markets, and make it easier for regulators to detect risk in sovereign debt markets. Regulators will also gain clear powers to restrict or ban short selling in exceptional situations, in coordination with the ESMA. The proposals are a further step towards greater financial stability in Europe."

At the same time, the EC tabled a further regulatory proposal concerning the OTC derivatives market. Currently, it says, reporting of OTC derivatives is not mandatory and, as a result, policy makers, regulators and market participants do not have a clear overview of what is going on in the market.

It is therefore proposed that trades in OTC derivatives in the EU will have to be reported to central data centres, known as trade repositories, and be accessible to supervisory authorities, with more information being also made available to all market participants. The ESMA will be responsible for the surveillance of trade repositories and for the granting or withdrawal of their registration.

The EC also proposes that standard OTC derivative contracts be cleared through central counterparties (CCPs) to reduce counterparty credit risk. This, it was said, would prevent the situation where a collapse of one market participant causes the collapse of other market participants, thereby putting the entire financial system at risk.

If a contract is not eligible and therefore not cleared by a CCP, different risk management techniques would have to be applied (such as requirements to hold more capital). As CCPs are to take on additional risks, they will be subject to stringent business conduct and harmonized organizational and prudential requirements – such as internal governance rules, audit checks and greater requirements on capital.

These proposals, which the EC says are fully in line with the EU's G-20 commitments and the approach adopted by the United States, will now pass to the European Parliament and the European Council for consideration. If adopted, the regulations would apply from end-2012.

Michel Barnier said: "No financial market can afford to remain a Wild West territory. OTC derivatives have a big impact on the real economy: from mortgages to food prices. The absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from. We are proposing rules which will bring more transparency and responsibility to derivatives markets.”

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