Commission published FAQ on short selling and CDS

19 October 2011

During the financial crisis and in the context of market volatility in euro denominated sovereign bonds, Member States reacted differently to the issues raised by short selling and credit default swaps. This legislative framework at European level will deal with these issues in a coherent way.

What is short selling?

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.

Who engages in short selling and why?

Short selling is used by a variety of market participants including hedge funds, traditional fund managers such as pension funds and insurance companies, investment banks, market makers and individual investors. Short selling can be used for the following reasons:

• for speculative purposes (e.g. to profit from the expected decline of a share price);
• to hedge a long position (e.g. to limit losses in comparable shares in which a long position is held);
• for arbitrage (e.g. to profit from the difference in price between two different but inter-related shares); and
• for market making (e.g. to meet customer demand for shares which are not immediately available).

What is a credit default swap?

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. 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.

Who trades in CDS and why?

There are four main groups of market participants in the CDS market: dealers, non-dealer banks, hedge funds and asset managers. The dealers are by far the largest players on the market. The aims of these market participants are diverse and they employ different strategies. CDS can be used for the following purposes:

• hedging: CDS can be used to neutralise or reduce a risk to which the CDS buyer is exposed from another position. An example of such an "insurable interest" would be a bondholder's exposure to the credit risk of the issuer of the bond; by buying a CDS he can reduce that risk by passing it on to the CDS seller;
• arbitrage: The typical arbitrage operation that involves CDS is the combination of buying a CDS and entering into an asset swap where the fixed coupon payments of a bond are swapped against a stream of variable payments; or
• speculation: CDS can also be used to take a position in order to exploit price changes by trading in and out. For example, a CDS seller has taken on risk (in exchange for the regular payments he receives from the CDS buyer); he will gain from the contract if the credit risk does not materialise during the contract's term or if the compensation received will exceed a potential payout.

Why did the Commission propose legislation on short selling and CDS?

During the financial crisis and more recently in the context of market volatility in euro denominated sovereign bonds, Member States reacted differently to the issues raised by short selling and credit default swaps. A variety of measures have been adopted using different powers by some Member States while others have not taken action. There is currently no legislative framework at European level to deal with these issues in a coherent way. A fragmented approach to these issues 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 for investors.

While the Commission acknowledges that short selling has economic benefits and contributes to the efficiency of EU markets, notably in terms of increasing market liquidity, more efficient price discovery and helping to mitigate overpricing of securities, it also presents risks.

While reducing the scope for regulatory arbitrage and compliance costs arising from a fragmented regulatory framework, the three main risks of short selling which the Commission sought to address in the Regulation are:

• transparency deficiencies: the current lack of transparency in relation to short selling prevents regulators from being able to detect at an early stage the development of short positions which may cause risks to financial stability or market integrity. Greater transparency to the market on short selling would deter aggressive short selling and give useful information to the market about how short sellers view the performance and prospects of companies.
• the risk of negative price spirals: many regulators have expressed concerns about the risks of short selling amplifying price falls in distressed markets, and that this could lead to systemic risks. It was due to these concerns that a number of Member States introduced emergency measures to restrict or ban short selling in some or all shares in autumn 2008. Concerns have also been expressed by some Member States that short positions through CDS transactions could in some circumstances contribute to a decline of sovereign bond prices.
• the risks of settlement failure associated with naked short selling: when a short seller sells a financial instrument short without first borrowing the instrument, entering into an agreement to borrow it, or locating the instrument so that it is reserved for borrowing prior to settlement ("naked short selling"), there is a risk of settlement failure. Some regulators consider that this could endanger the stability of the financial system, as in principle a naked short seller can sell an unlimited number of shares in a very short space of time.

The regulation agreed by the European Parliament and Council addresses both short selling and CDS because CDS can be used to secure a position economically equivalent to a short position in the underlying bonds. The buyer of a naked CDS benefits from the deterioration of the credit risk of the issuer in a very similar manner to the benefit which the seller of the bonds derives from this same deterioration which decreases the prices of the bonds.

What are the objectives of the regulation?

The objectives of the proposal are to:

• increase transparency on short positions held by investors in certain EU securities;
• ensure Member States have clear powers to intervene in exceptional situations to reduce systemic risks and risks to financial stability and market confidence arising from short selling and credit default swaps,
• ensure coordination between Member States and the European Securities Markets Authority (ESMA) in exceptional situations;
• reduce settlement risks and other risks linked with uncovered or naked short selling; and
• reduce risks to the stability of sovereign debt markets posed by uncovered ("naked") CDS positions, while providing for the temporary suspension of restrictions where sovereign debt markets are not functioning properly.

How does the regulation enhance the transparency of short selling?

Transparency is key in ensuring the efficient functioning and monitoring of financial markets. So the Regulation provides for several measures to enhance transparency in short selling for shares and government debt.

For shares: For EU shares the provisions to enhance transparency are largely based on the two tier model recommended by CESR (the Committee of European Securities Regulators, the predecessor of ESMA) in its report in March 2010. At a lower threshold (0.2 per cent of the issued share capital) notification of a short position will be made only to the regulator and at a higher threshold (0.5 per cent) short positions will be disclosed to the market. Notification to regulators will enable them to monitor and, if necessary, investigate short selling that may pose systemic risks or be abusive. Publication of information to the market will provide useful information to other market users and act as a disincentive to aggressive short selling strategies.

The regulation also calls for consideration to be given by the Commission, in the context of the revision of the Markets in Financial Instruments Directive (MiFID), to whether inclusion by investment firms of information about short sales in transaction reports to competent authorities would provide useful supplementary information to enable competent authorities to monitor levels of short selling.

For sovereign bonds: A specific regime for notification to regulators only of significant net short positions in EU sovereign bonds is set out in the regulation. This includes notification of significant credit default swap positions relating to sovereign debt issuers. Disclosure to regulators of significant net short positions relating to EU sovereign bonds will 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 provisions on sovereign bonds provide for information to be disclosed only to regulators rather than to the market, as public disclosure could have negative consequences for the operation of sovereign bond markets, notably in terms of liquidity. The evidence from the existing short selling disclosure regimes for shares at national level is that these have not had an undue impact on the liquidity of share markets.

In order to avoid any circumvention of the short selling disclosure rules through off-exchange derivative transactions, the transparency requirements for EU shares and EU sovereign bonds also cover the use of derivatives to obtain a net short position relating to the shares or bonds. The regulation also requires that short positions should be subtracted (or 'netted off') from long positions, as notification of a net short position provides more meaningful information to regulators and/or the market.

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