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On 21 February, the Economic and Financial Affairs Council adopted new rules for short selling and certain aspects of credit default swaps. The regulation introduces common EU disclosure requirements and harmonises the powers that regulators may use in exceptional situations where there is a serious threat to financial stability. The regulation - which also had to be agreed by the European Parliament - covers all types of financial instrument, but given the potential risks posed by short selling, this form of trading is a central element to be governed by the new rules.
Transparency rules
For significant net short positions in shares of EU listed companies, the regulation creates a two-tier reporting model. At a lower threshold, positions must be reported privately to regulators so that the latter can detect and investigate short sales that might constitute abuse or create systemic risks. At a higher threshold, positions must be disclosed to the market in order to provide useful information to other market participants.
For sovereign debt, significant net short positions relating to issuers in the EU will always require private disclosure to regulators. The text also provides for notification of significant positions in credit default swaps that relate to EU sovereign debt issuers.
What is short selling?
Short selling is a practice whereby investors sell a security that they do not own but whose delivery is promised, with the intention of buying it back later. If the security price drops, the short sellers, after having bought back the securities in question, profit from the price difference. Short selling is a common practice in most financial markets. Although it most often occurs in share trading, it is not unusual in the selling of other types of financial instruments, for example, government bonds.
Short selling can roughly be divided into two types: 1) covered short selling, where the seller has borrowed the security, or made arrangements to ensure they can be borrowed before the short sale is done; 2) uncovered (or naked) short selling, where at the time of the short sale the seller has not borrowed the securities or ensured they can be borrowed.
Restrictions for uncovered short selling
To mitigate the greater risks created by uncovered short sales, anyone entering into a short sale must at the time of the sale have borrowed the instruments, entered into an agreement to borrow them or have made other arrangements to ensure they can be borrowed in time to settle the deal. These restrictions do not apply to the short selling of sovereign debt if the transaction serves to hedge a long position in debt instruments of an issuer. Furthermore, if the liquidity of sovereign debt falls below a specified threshold, the restrictions on uncovered short selling may be temporarily suspended by the regulator.
Regulators' powers in exceptional situations
In exceptional situations, regulators may temporarily require further transparency or restrict short selling and credit default swap transactions. In such a situation, the European Securities and Markets Authority (ESMA) would coordinate action between regulators to ensure that measures are truly necessary and proportionate. The ESMA is also given powers to take measures where the situation has cross-border implications.