In September 2010, at Germany and France request, the European Commission put forward a proposal for a regulation on short selling and certain aspects of Credit Default Swaps (CDS). The draft regulation will harmonise requirements relating to short selling in the EU as well as the powers that regulators may use in exceptional situations, in case of serious threat to financial stability or market confidence. Moreover, it will entail further transfer of powers from national regulators to the new European Securities and Markets Authority (ESMA).
The Financial Secretary to the Treasury, Mark Hoban, said to the European Scrutiny Committee that “the Financial Services Authority maintains a disclosure regime in relation to short positions in stocks in UK financial sector companies as a proportionate response to any outstanding or future risk short selling may present;” He recalled that the Market Abuse Directive already forbids short selling which is carried out in connection with abusive strategies. Moreover, under the Financial Services Act 2010, the Financial Services Authority has powers “to take action against short selling” as well as “to impose a disclosure regime on equities;” Consequently, there is no need for further EU regulations on short selling.
The Government does not support the Commission’s proposals on disclosure requirements and restrictions on naked short selling relating to sovereign debt as they are likely to have an adverse impact on sovereign bond markets as well as on a sovereign's cost of borrowing. According to the Government, the Commission’s proposal “implies significant and unmet ongoing costs for both firms and individuals, trading venues and clearing houses in establishing the infrastructure necessary to meet its requirements.” The UK, Italy, as well as other Member States have opposed to the proposal to restrict uncovered short-selling, particularly of sovereign bonds. According to these countries such measure would increase the costs for governments seeking to raise money to finance their debt. However, the draft regulation is subject to the ordinary legislative procedure with QMV required at the Council, and the UK could not water down the proposals.
The European Parliament, the Council and the European Commission have recently agreed a compromise deal that curtails the practice of short-selling EU shares and bonds. They agreed to permanently ban trading in "naked credit default swaps." The compromise deal still has to be formally approved by the Council and the European Parliament. The regulation on short selling and certain aspects of Credit Default Swaps (CDS) is expected to be adopted before the end of the year and to enter into force on 1 November 2012. Unfortunately, this will be another example of the UK being outvoted on EU financial regulations.
The draft Regulation provides for exemptions for market making activities, for primary market operations and for shares of a company admitted to trading on a trading venue in the EU where the principal venue for the trading of the shares is located in a country outside the EU. Hence, the draft regulation’s transparency requirements will apply to all “natural or legal persons with significant net short positions relating to EU shares and EU sovereign debt” as well as “to natural or legal persons with significant credit default swap positions relating to EU sovereign debt issuers.” Traders that short-sell considerable amounts of shares would be obliged to disclose their positions to regulators and to the market. Private disclosure to regulators would be required as regards significant net short positions relating to sovereign debt issuers in the EU. Any natural or legal person that has a net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue would be required to notify the national regulator whenever the position reaches or falls below a notification threshold which is 0.2% of the value of the issued share capital of the company. Higher threshold positions must be disclosed to the market. Hence, investors that have a net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue would be required to disclose to the public details of the position every time the position reaches or falls below a publication threshold which is 0.5% of the value of the issued share capital of the company. Moreover, a natural or legal person would be required to notify regulators of any “significant net short positions” in sovereign debt and credit default swaps every time such position reaches or falls below a notification threshold for the Member State concerned or the EU. The Commission would be empowered to introduce measures specifying these notification thresholds through delegated acts (comitology procedure).
The draft regulation provides for restrictions on naked short selling and requirements aimed at addressing the potential risk of settlement failure and market volatility associated to uncovered or naked short selling of shares and sovereign debt. Consequently, traders would be seriously restricted to be engaged in naked short selling of shares.
Despite UK’s opposition, the Regulation agreed by the European Parliament and the Council addresses both short selling and CDS. Under the compromise deal a permanent ban on naked short selling of bonds and shares, and on so-called naked credit default swaps is to be imposed within the EU. The European Conservatives and Reformists Group have been against an extension of the ban to naked CDS. According to Syed Kamall MEP, "Some banks could also see their credit lines withdrawn and a ban would make it much more expensive for governments to raise money by issuing bonds. This means higher taxes and a bigger squeeze on public services in the UK…”
Under the draft regulation, investors may only enter into a short sale of a share admitted to trading on a trading venue if, at the time of the sale, they have borrowed the share, have entered into an agreement to borrow the share or have made arrangements with a third party in order to ensure that the instrument can be borrowed. As regards sovereign debt, investors may only enter into a short sale if they have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party in order to ensure that the security can be borrowed. Under the compromise deal such 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.”
The Regulation introduces, therefore, a requirement for a permanent ban on "naked" sovereign CDS. Taking into account that there is no evidence that short selling of sovereign debt or sovereign credit default swaps has contributed to the financial crisis, the Government was seeking to remove all references to sovereign debt from the proposal. The prohibition of naked CDS on sovereign debt is therefore a victory for the European Parliament and a blow to the UK.
The MEP's position was more restrictive than that approved by the Council and included a ban on naked sales of credit default swaps. Spain and Italy were also against a CDS ban but they agreed to it after an opt out has been negotiated with the European Parliament. Hence, under the compromise agreement, in order to deal with concerns that CDS curbs could negatively affect the liquidity of sovereign debt markets, a competent authority (national regulators) may temporarily suspend the restrictions, and lift the ban, if they believe that it is harming their sovereign debt market. However, this possibility would be very limited. National regulators would have to show their sovereign debt market is not functioning properly and that such restrictions could have “a negative impact on the sovereign credit default swap market, especially by increasing the cost of borrowing for sovereign issuers or affecting the sovereign issuer's ability to issue new debt.” The decision of the national regulators to temporarily suspend the restrictions would have to be based on “objective elements”, which would have to be based on indicators specified in the draft regulation, such as “high or rising interest rate on the sovereign debt.” Moreover, the national regulators would be required to notify ESMA, before suspending the restrictions, as well as other national regulators about their intentions and the “objective elements” on which the suspension is based. Then, within 24 hours, ESMA will issue an opinion on the intended suspension of the ban. Obviously, ESMA may approve or reject the opt out, but, it seems that ESMA’s opinions will not be biding. However, according to French MEP and rapporteur for the draft regulation, Pascal Canfin, "ESMA won't have any power to impose its decision but there will be political pressure and there will be judicial pressure if the framework is not respected," Under the compromise deal, the ban on naked CDS can be suspended for one year, renewable for further periods of up to 6 months. Furthermore, national regulators may temporarily suspend, for a renewable 6 month period, the above-mentioned restrictions “where the liquidity of the sovereign debt falls below a pre-determined threshold.” This will de decided by the Commission in a delegated act.
Michel Barnier said that "These balanced measures will ensure that sovereign CDS are used for the purpose for which they were designed, hedging against the risk of sovereign default, without putting at risk the proper functioning of sovereign debt markets." However, it is believed that a ban on naked CDS would have "detrimental effects on liquidity". According to the Daily Telegraph, Andrew Baker, CEO of the Alternative Investment Managers’ Association (AIMA) said the ban “could not only reduce liquidity and increase volatility in debt markets, but also increase government borrowing costs and reduce real economy investments in EU member states."
The draft proposal also aims to harmonise national financial regulators’ powers as well as the conditions and procedures to prohibit or restrict short selling activities and credit default swaps. Hence, under the draft regulation, in case of exceptional circumstances, when adverse developments constitute a serious threat to financial stability in a member State or the EU, national regulators would have powers to restrict or ban short selling in any financial instrument, credit default swaps and other transactions, subject to coordination by ESMA. The national regulators’ powers of intervention relating to short selling and credit default swaps in exceptional situations would be temporary. Hence, a temporary measure can be introduced for three months, and then be extended for another three months, but this must be justified. Unsurprisingly, the Commission will adopt measures, through delegated acts, specifying criteria and factors to be taken into account by competent authorities and ESMA while deciding when an exceptional situation arises.
Under the draft proposal, member states’ competent authorities would also be given the power to impose a temporary restriction on short selling of a financial instrument, in case of a significant fall in the price of the instrument on a trading venue in a single day, until the end of the next trading day or up to a further two trading days. However, before imposing such measures, they would be required to notify ESMA. ESMA will then inform the competent authorities of the other member states whose trading venues trade the same instrument, so that the same measures can be applied by them. If national regulators disagreed over this matter and cannot reach an agreement, ESMA has legally biding mediation powers to settle such dispute. Hence, ESMA may take a decision requiring national regulators to take specific action or to refrain from action, “with binding effects for the competent authorities concerned, in order to ensure compliance with Union law.” It would, therefore, override, in this way, national regulators’ decisions.
ESMA will “perform a facilitation and coordination role in relation to measures taken by competent authorities” in exceptional situations. Moreover, member states’ competent authorities must notify ESMA of the measures they intend to introduce within one day. Then, ESMA, within 24 hours, will issue an opinion stating whether the proposed measure is suitable to address the threat and whether the duration of the measures is justified. ESMA might also consider that other competent authorities should take such measures. If a national regulator decides to take measures contrary to an ESMA’s opinion it would be required to fully justify its decision. Then, ESMA would consider whether to use its intervention powers. Such intervention powers are based on article 9(5) of the ESMA’s regulation, which allows the agency to "temporarily prohibit or restrict certain financial activities that threaten the orderly functioning and integrity of financial markets."
The draft regulation will transfer national regulators’ powers to deal with emergency situations to ESMA, as regards financial instruments other than sovereign debt or sovereign CDS. According to Euractiv, Pascal Canfin said "The European financial markets agency (ESMA) will now have the power to impose its decisions on equity markets on national regulators. Parliament would have preferred that ESMA had the same prerogatives on sovereign debt matters but, regrettably, this was refused by member states in the negotiations.”
ESMA would be empowered to require investors who have net short positions in relation to a specific financial instrument to notify a competent authority or to disclose such position details to the public. It may also forbid or impose conditions relating to investors from entering into a short sale or into transactions relating to financial instruments or limit the value of transactions in the financial instrument that may be entered into. Under the draft proposal, ESMA would be given the power to take such measures if they are necessary to address a threat to the functioning of financial markets or the stability of the EU financial system, if the situation has cross border implications and if the competent authorities have not taken measures or the measures taken were not adequate to address the threat. ESMA would be required to notify competent authorities of the measure it proposes. But, the proposed measures will take effect when ESMA publishes on its website notice of any decision to impose. ESMA would be, therefore, empowered to adopt measures with direct effect, limiting or forbidding short selling. Under the draft proposal any measure adopted by ESMA would prevail over any previous measure taken by a national regulator. Hence, in the abovementioned situations, ESMA would be able to override measures taken by national regulators.
The UK has been demanding for ESMA’s powers to be limited. One could say that ESMA’s emergency powers to impose trading restrictions are illegal.
It is important to recall that the ECJ has decided on the limits to the delegation of powers to agencies in the 1958 Meroni judgment (Meroni & Co., Industrie Metallurgiche, SpA v High Authority of the European Coal and Steel Community). The Court set up a general principle “A delegating authority cannot confer upon the authority receiving the delegation powers different from those which it has itself received under the Treaty.” According to the Court the discretionary delegation of powers to bodies, which are not foreseen in the treaty, would imply a wide margin of appreciation, replacing “the choices of the delegator by the choices of the delegate”, entailing, in this way, “an actual transfer of responsibility”, which would infringe the ‘principle of institutional balance.’ The Government noted that the proposed provisions conferring on ESMA the power to temporarily prohibit or restrict certain financial activities, entails a “wide discretion.” According to the European Scrutiny Committee “there is a significant risk that Article 24 is unlawful in that it delegates too much power to the European Securities and Markets Authority, in breach of the Meroni principle.” However, the majority of the member states do not share the Government concerns about the extent of ESMA's powers.
