The Long And Short Of It: EU Regulation On Short Selling And Sovereign CDS

Author:Mr Peter Green, Jeremy C. Jennings-Mares and Nimesh Christie
Profession:Morrison & Foerster LLP
 
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The Council of the European Union (the "Council") has adopted a regulation (the "Regulation")1 on short selling and certain aspects of credit default swaps ("CDS"), which aims to create a harmonised short selling and sovereign CDS regime across the European Union (the "EU") and also to align the powers that regulators from different member states may use in exceptional circumstances. The Regulation was published in the Official Journal of the EU on 24 March 2012 and will come into force on 1 November 2012 at which time it will become directly applicable in all EU member states.

Background

As we have mentioned in previous updates, the Regulation was conceived out of the need to harmonise the fragmented approach of different regulators throughout the EU towards restricting short selling and the use of CDS, which, according to the Council in its press release2 on the adoption of the Regulation, limits the effectiveness of adopted measures and results in regulatory arbitrage. The Regulation seeks, in particular, to improve the transparency related to significant short positions and address risks of negative price spirals and settlement failures, especially in relation to uncovered or 'naked' short selling. This update summarises the main provisions of the Regulation, describes major changes from previous texts of the Regulation, and considers the Regulation's potential implications in practice.

Scope of the Regulation

The Regulation has been broadly drafted to include the short selling of equity securities and sovereign debt (as well as transactions referencing such securities) and the buying of credit protection through CDS in relation to sovereign debt. The Regulation will apply, so far as possible, to those entering into trades rather than intermediaries.

Key Provisions of the Regulation

Disclosure

The Regulation creates a two-tier disclosure regime of public and private disclosure in relation to equity securities, and also introduces disclosure requirements for the shorting of sovereign debt and trading in naked sovereign CDS as summarised in the table below.

Equity (Private Notification)

Equity (Public Notification)

Sovereign Debt

Naked Sovereign CDS

When notification obligation arises

Net short position at midnight in relevant member state at end of trading day reaches or falls below 0.2% of issued share capital, and each 0.1% above that, up until 0.5%.

Net short position at midnight in relevant member state at end of trading day reaches or falls below 0.5% of issued share capital, and each 0.1% above that.

Net short position at midnight in relevant member state at end of trading day reaches or falls below thresholds to be set by the Commission. ESMA to publish notification thresholds on its website.

Where restrictions on uncovered positions in sovereign CDS are suspended, notify when net short position at midnight in the relevant member state at end of the trading day reaches or falls below thresholds for sovereign debt set by the EU Commission.

Who to Notify

Private notification to the relevant competent authority, where the relevant share was first admitted to trading.3

Public notification through the relevant competent authority where the relevant share was first admitted to trading.

Private notification to the relevant competent authority of the member state issuer. Where the issuer is the EU or an associated institution, notification to the competent authority of the jurisdiction where the entity issuing debt is situated.

Private notification to the relevant competent authority.

In each case, notification must be made by 3.30 p.m. on the following trading day in the relevant member state. The notification must specify the identity of the person holding the position, the size of the short position, the entity in relation to which the position is held, and the date on which the position was created, changed or ceased to be held.

The Regulation envisages that all short positions be reported within the same timeframe, which could give rise to difficulties in relation to certain derivative positions (particularly basket transactions) which take longer to calculate. The disclosure requirement is at an individual entity level, rather than at a group level. However, the Commission is entitled to adopt delegated acts to set out provisions for calculating net short positions in complex entities, and it is expected that such delegated acts will be subject to substantial negotiation, within the parameters set by the Regulation, before being finalised.

The calculation of net short positions is required to take into account all long and short positions which the holder has in relation to the relevant shares or sovereign debt as well as any other form of economic interest therein. In particular, it is required to take into account interests obtained directly or indirectly through the use of derivatives (including options, futures and contracts for differences) and indices, baskets of securities and exchange traded funds. In the case of positions relating to sovereign debt it should also take into account credit default swaps relating to sovereign debt issuers.

The Regulation also obliges holders of short positions to keep records for five years of their net short positions, as well as the gross positions supporting these net short positions. Also, the requirement to identify short sales in...

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