Financial Regulatory Forum

Europe’s naked short selling ban leaves investors with skin in the game

By Guest Contributor
December 4, 2012

By Christopher Elias

LONDON/NEW YORK, Dec. 4 (Business Law Currents) – New European short selling regulations are dressing naked short sellers in a regulatory straightjacket, but ill-fitting provisions may leave investors with skin in the game.

In force since 1 November 2012, the regulations were supposed to curb naked short selling and to provide transparency on those trading against European sovereign debt. However, with gaps between short selling methods and alternatives popping up in exchange traded futures and synthetic forms, the holes are already becoming apparent.

Part disclosure regime, part (naked) sovereign shorting ban, the European regulations impact a wide variety of trades and there are signs that the markets are already adjusting.

Broadly speaking, the rules ban the shorting of European sovereign debt other than as a hedge, and require the disclosure of substantial short positions in listed European companies.

The rules have already revealed the previously secret shorts of Maverick Capital Ltd, Greenlight Capital Inc and Kynikos Associates LP, as their bets on the underperformance of Home Retail Group, Daily Mail & General Trust and Ocado Group have become public knowledge.

Giving notice

Under the new regime, participants in short selling – the act of borrowing securities, selling them on loan and seeking to buy them back at a lower price to make a profit – will need to notify European authorities when they intend to short sell 0.2 percent or more of the shares of a company that are available to the market. Short sellers will also be required to publicly reveal net short positions of more than 0.5 percent in any one company.

To date 474 short disclosures have been made to the UK’s FSA alone, on a range of companies from Admiral Group to XP Power.

Most heavily shorted (by number of disclosures) so far has been Lonmin plc , a producer of platinum group metals operating in the Bushveld Complex in South Africa that recently saw 45 people die in a bloody dispute with trade unions. According to FSA filings, 26 short selling disclosures above the 0.5 percent threshold were made to the FSA regarding Lonmin since the beginning of the month, although a number of those disclosures related to the same short sellers.

The regulations require that net short positions are notified to regulators by no later than 3:30 pm on the following day. Net short positions of 0.2 percent or more of the issued share capital of a company must be reported privately to the regulator that is the home member states’ competent authority of the relevant issuer (e.g. the FSA for UK’s issuers).

Additional reports must be made if the short position reaches each 0.1 percent threshold thereafter (i.e. 0.3 percent, 0.4 percent and 0.5 percent). A report will also need to be made where a firm’s net short position falls below the relevant thresholds.

Upon reaching 0.5 percent of the issued share capital, and at each 0.1 percent threshold thereafter, the net short position must also be reported to the market.

The rules build upon previously enacted emergency short selling measures and upon the FSA’s existing short selling rules that apply to rights issues and shares in UK financial service companies. They also go beyond existing short selling rules by significantly curbing some short selling activity.

Uncovered “naked” shorts

Perhaps most controversial are the new rules on uncovered and naked short positions. “Naked” shorts are positions whereby a firm sells shares that they do not own or have not borrowed.

Unlike a “normal” short selling scenario, a naked short seller will not buy or borrow the shares before selling them on. Instead the seller will hope to purchase the shares prior to delivering on its sale or in some cases will just fail to deliver those shares.

By way of illustration, suppose a naked short seller sells shares in Company A at $50 each for delivery in three days time. The seller will then hope that the value of Company A’s shares fall in the interim period so that he or she can purchase those shares at less than $50 before delivering them to the buyer whilst pocketing the difference.

The process of naked short selling can lead to what are known as “failed to deliver” notices – instances whereby the short seller is unable to obtain the securities and therefore fails to deliver them to the buyer. Although far from conclusive, such fail to delivers have been charged with creating market volatility and potentially sharp decreases in a company’s share value.

The new regulations seek to largely do away with naked short selling by requiring firms to have either borrowed or be able to borrow shares to cover their short positions or in the case of sovereign borrowing to have some corresponding hedge.

In respect of company shares the regulations require either that a firm has:

  • Borrowed sufficient shares to settle the short trade;
  • Entered into a binding agreement to borrow those shares; or
  • Has an arrangement with a third party under which the third part has confirmed that the shares have been located and there is a reasonable expectation that they will be delivered.

Naked sovereigns

Curiously, the regulations are rather more relaxed in relation to naked sovereign or credit default swap (CDS) positions than in relation to company shares. Even more perplexing are that the rules are subtly different for CDS positions and for uncovered short positions- a difference that may have ramifications for market participants.

Both CDS and uncovered short positions do not require a firm to have borrowed or be able to borrow securities, provided that the position is being used for the purposes of a permitted hedge.

Perplexingly, what constitutes a permitted hedge, however, differs between credit default swap positions and more straight forward shorting. For uncovered short positions, a sovereign debt short will be permitted if it is being used to hedge a long position in the debt instruments of an issuer, the pricing of which has a “high correlation” (80 percent according to ESMA FAQs) with the pricing of the sovereign debt.

By contrast a naked CDS is required to hedge against the risk of default of the issuer where the short seller has a long position in the sovereign debt or other financial contract that is correlated (but not “highly”) with the risk of decline of the sovereign debt.

The correlation between CDS and sovereign debt may be judged quantitatively (with a co-efficient of at least 70 percent) or qualitatively using historical information from the previous 12 months and includes indirect exposures obtained through funds, indices or special purpose vehicles.

The distinction seems to suggest that CDSs may offer more flexibility to short sellers than short sovereign bond positions. The CDS 70 percent correlation is lower than the sovereign bond 80 percent correlation and includes more types of financial instruments. Whereas bond short sellers must have a correlating debt instrument, a CDS could match sovereign debt to a more diverse universe of financial contracts.

Despite the fact that the regulations are barely in force, there are signs, however, that some investors have already found a way around the regulations.

Back to the future(s)?

As Europe clamps down on CDSs and sovereign shorting, there has been a sharp uptick in the number of investors using exchange traded futures. Capable of performing in an economically similar way to CDSs or short positions, investors may be plowing into these more lightly regulated instruments.

IFR, a Thomson Reuters publication, noted recently that on the eve of the short selling rules coming into force, flows into futures had increased dramatically. Not included within Europe’s short selling regulations, exchange-traded government bond futures may be being used by some to evade the ESMA restrictions.

Open interest in Eurex-listed Italian BTP futures has almost doubled since the announcement of the ban back in March, from 32,271 to a new peak of 62,489 according to IFR.

Volumes in OAT futures have rocketed even more sharply with open interest reaching a high of 146,923 on October 24 despite the contracts only launching in April.

The futures provide similar economic exposures to CDSs or short selling of European sovereign debt but without the restrictions imposed by the regulations. The impact of which may be to move naked or other short selling from over-the-counter world to exchange traded futures.

As well as futures, exchange traded funds (ETFs) have begun offering investors a synthetic alternative to buying or selling sovereign debt. Shortly after the regulations were announced, Deutsche Bank launched DB X-trackers that offer daily leveraged exposure to U.S. and UK sovereign debt.

Funds of this type allow investors to go long or short against the sovereign bond market without having to buy bond futures contracts, which in some cases can prove costly.

Four db X-trackers funds were listed on the London Stock Exchange on 17 May and include a U.S. Treasuries Double Long Daily ETF, a U.S. Treasuries Double Short Daily ETF, a UK Gilts Double Short Daily ETF and a UK Gilts Double Long Daily ETF.

The issue follows leveraged short ETFs on German and Italian bonds launched by Lyxor in 2010.

These funds offer a way for investors to short sovereign debt without having to do the shorting themselves. They also offer another way that investors might keep their shorts on despite the naked short selling ban.

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com)

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