Banks and industry bodies have criticised the European Securities and Markets Authority’s (Esma’s) draft rules on short-selling and credit default swaps, with UBS and Deutsche Bank singling out the draft locate arrangements as an area of key concern.
“Using the definition for liquid share of the Markets in Financial Instruments Directive (Mifid) is inappropriate as it is used to determine if a quoting obligation should apply,” said Andrew Proctor, Deutsche Bank’s global head of government and regulatory affairs in the bank’s comment letter. “It does not relate to the availability of shares to put in place a borrowing arrangement.”
The proposed requirement to confirm the effective allocation of shares by having a third party put illiquid shares on hold will have a significant market impact, added Proctor.
It risks leading to a daily practice where a firm must ask a third party for shares to be put on hold in case it wants to make a short sale. At the end of the trading day, the firm might not actually have taken the short position.
“As this would happen on a daily basis some illiquid shares would be put on hold indefinitely, thus effectively taking them out of circulation,” said Proctor.
Four influential industry bodies also added their voices to the debate, taking issue with the provision of exhaustive lists of agreements, arrangements and third parties. The Association for Financial Markets in Europe, the International Capital Market Association, the International Securities Lending Association and the International Swaps and Derivatives Association said the lists do not include agreements or entities that are commonly used for covering of short sales.
The definition of third party should not preclude the use of a specialist internal repo or securities lending desk, they added.
The City of London Law Society also disagreed with the use of an exhaustive list, suggesting that if a list is included, it should be a non-exhaustive list of examples only.
But according to the European Banking Federation, an exhaustive list provides certainty and clarity to all market participants. The authority did say that, to retain a degree of flexibility, the lists should be reviewed and updated on a regular basis.
Derivatives clearing house ICE Clear Europe suggested that the regulation’s reference to entering into an uncovered credit default swaps (CDS) should be narrowly construed so that it only applies to voluntarily entered into transactions.
“If a narrow interpretation is not adopted, the prohibition on uncovered CDS in the proposed regulation could have the unintended effect of catching and restricting the activities and default management practices of CCPs [central clearing parties],” said Paul Swann, president and chief operating officer of ICE Clear Europe.
ICE’s clearing rules include provisions that allow it to allocate the positions of an insolvent clearing member to other clearing members. If ICE needs to use this procedure in relation to a position in sovereign CDS, it would be without knowledge of transferee clearing members’ underlying sovereign bond holdings.
“It is therefore possible that in requiring transferee clearing members to fulfil their contractual obligation to take on the position, or part of the position, ICE would inadvertently be obliging them to assume an uncovered position in sovereign CDS,” said Swann.
If a narrow interpretation is not possible, ICE suggested that the proposed regulation should exempt CCPs from Article 14, where positions in uncovered CDS are assumed for the purpose of providing CCP services.
A number of comment letters referred to the limited timeframe Esma was given to prepare and consult the industry on its technical standards, warning that it impinge their quality. The general consensus was that more time is needed to assess how the proposed requirements would impact the market.
Other responses warned that the proposed interpretation of the grandfathering rule could result in retrospective effects of the ban on uncovered sovereign CDS, which risks introducing legal uncertainty, increasing prices of the sovereign CDS protection or significantly reducing its availability and so increasing funding costs for the sovereign and corporate debt markets.
Peter De Proft, director general of the European Fund and Asset Management Association, said it was odd that Level 2 proposals will have been set out before the final text of the regulation has officially entered into force.