EU short selling: what US funds need to know

Author: Gemma Varriale | Published: 7 Nov 2012
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The EU’s tough new short selling regime became effective on November 1. Its impact stretches far beyond the EU’s borders, but there is still uncertainty among non-EU investors as to what they should be doing.

Finalised in March, the regulation significantly restricts traders’ ability to short-sell bonds and shares and buy credit insurance. The regime came into force four years after individual countries imposed their own short-selling bans following market turmoil caused by the Lehman Brothers collapse.

Key features include new reporting obligations for significant net short positions in the European Economic Area (EEA) listed shares and sovereign debt, a ban on naked physical short sales of EEA listed shares and sovereign debt; and a wide-ranging ban on credit default swap (CDS) positions in EEA debt.

“At the highest level, it’s better to have one set of rules across the whole EU than 27 different regimes,” said Adrian Hood, regulation adviser with the Investment Management Association. “However, the process by which we got this regulation and the detail of it is far from satisfactory.”

Questionable benefits

Short selling is the process through which investors borrow stock they believe is overvalued, sell it, and buy it back to return to the owner once the price has fallen.

According to Hood, the European Securities and Markets Authority (Esma) has failed to give sufficient guidance on issues as basic as definitions of what is and isn’t caught.

But the situation gets even more complex because the wide-ranging regulation covers trading both inside and outside the EEA. It marks the first time that a European regulation has a direct impact on the trading activities of US entities that is conducted entirely offshore.

David Freedman, a partner with Baker & McKenzie in New York said the regulation impacts everybody, everywhere. “While that shouldn’t come as a surprise, people were not necessarily fully prepared for it,” he said.

Indeed, the new rules have hit US firms already dealing with a substantial Dodd Frank compliance burden particularly hard.

One key implication for firms outside the EU is the level of internal systems configuration. Market participants must find out whether they have a reportable position regarding both shares and sovereign debt. If they have a sovereign debt CDS, they also need to know whether it’s deemed to be covered.

“There’s no de minimus exemption so investors have to look through everything they own everywhere and find out whether they need to report it,” said Freedman. “That’s just massive.”

And while Esma has said entities only need rely on publically available information to do the calculations, this still involves finding that information and monitoring when it changes on a real-time basis.

“There’s a very large cost and the benefits of having this reporting system are yet to be indicated or proven,” said Freedman.

There could also be competing layers of compliance for the same security. American depositary receipts (ADRs) are considered a US security for regulation SHO purposes, but will also be covered by the EU regime, unless it’s an exempted share.

Act now

So, what’s the advice for US investors? According to Freedman, it’s crucial to get systems up and running.

Those with a position indirectly via an index, basket of securities or an exchange traded fund (ETF) will need to find out on a real time basis before midnight of the relevant trading venue’s time whether they have a reportable position and be ready to disclose the following morning.

The time difference makes this particularly challenging for US-based asset managers.

“They need to get all their orders processed to make their calculations, then somebody has to go in early in the morning or stay late to make the filing,” said Freedman.

Freedman is also advising clients that if they haven’t already had to make a filing, they should pre-emptively get all of the log in details so they have them if they do have to make a filing.

“And when regulators say you have to do it electronically via the reporting platform, that means they don’t want an email, you have to upload it,” he added.

Investors are advised to review the list of exempted shares. Funds with a position on a company that should be on the list but isn’t, need to contact the competent authority for that issuer and ask them to amend the list.

Monitoring Esma’s Q&As is another tip. Questions can be sent to Esma to request clarification.

Hurricane Sandy meant that many Wall Street funds were closed last week. “That’s force majeure, but on the other hand there’s no exemption in the short-selling regulation for a hurricane battering Wall Street,” said Freedman.

See also

‘Banking sector reform: a definitive guide to the latest developments’ http://www.iflr.com/Article/3107360/Banking/Banking-sector-reform-a-definitive-guide-to-the-latest-developments.html