At the height of the financial crisis in September 2008, financial regulators in several EU Member States adopted emergency measures to restrict or ban short selling in some or all securities. These regulatory actions were prompted primarily by concerns that at a time of considerable financial instability, short selling can be highly disruptive and could aggravate the downward spiral in the prices of shares, notably in financial institutions, in a way which could ultimately threaten their viability and create systemic risks. These measures implemented by the EU member states were not coordinated as the EU does not yet have a common regulatory framework for dealing with short selling issues, resulting in divergent and fragmented sets of restrictions between the states.
In an effort to address regulatory fragmentation in short selling regulations throughout the EU, The European Parliament has adopted a regulation to harmonize the rules on short selling and credit default swaps.
Regulation (2010) 0482 (the "Regulation") is limited in scope and imposes restrictions on short selling and credit default swaps to prevent a disorderly decline in the price of a financial instrument. The Regulation does not impose other types of restrictions such as position limits or restrictions on products, however.
Permitted Short Sales
Under the Regulation, a person may only enter into a short sale of a share admitted to trading on a trading venue where one of the following three conditions is fulfilled.
- the person has borrowed the share or has made alternative provisions resulting in a similar legal effect;
- the person has entered into an agreement to borrow the share or has another absolutely enforceable claim to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due; or
- the person has 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 person to have a reasonable expectation that settlement can be effected when it is due.
Uncovered Shorts Sales in Sovereign Debt
The Regulation imposes similar restrictions on uncovered short sales in sovereign debt. However, 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.
Similarly, the Regulation imposes restrictions on uncovered credit default swaps in sovereign debt. Thus a person may enter into credit default swap transactions relating to an obligation of a sovereign issuer only where that transaction does not lead to an uncovered position in a credit default swap.
Under the Regulation, a position in a sovereign credit default swap will be considered "uncovered" when the swap does not serve to hedge against the risk of default of the issuer when the person has a long position in the sovereign debt of that issuer to which the sovereign credit default swap relates; or the risk of a decline of the value of the sovereign debt where the person holds assets or is subject to liabilities, including but not limited to financial contracts, a portfolio of assets or financial obligations the value of which is correlated to the value of the sovereign debt.
Central Counterparty Provisions
The Regulation requires that a central counterparty providing clearing services for shares must ensure that, when a person who sells shares is not able to deliver the shares for settlement within four business days after the day on which settlement is due, procedures are automatically triggered for the buy-in of the shares to ensure delivery for settlement. Similarly, when the buy-in of the shares for delivery is not possible, procedures must be in place to ensure that an amount is paid to the buyer based on the value of the shares to be delivered at the delivery date, plus an amount for losses incurred by the buyer as a result of the settlement failure.
Central counterparties must also have procedures ensuring that if a person who sells shares fails to deliver the shares for settlement by the date on which settlement is due, the person will be under the obligation to make daily payments for each day that the failure continues. The daily payments must be sufficiently high to act as a deterrent to failing to settle.
Implementation
To ensure uniform conditions of application of the Regulation, the European Securities and Markets Authority (ESMA) is directed to draft regulations determining the types of agreements and measures that adequately ensure that the shares will be available for settlement. ESMA is required to submit the draft implementing these standards to the European Commission by March 31, 2012.