European Regulators have issued new rules aimed at controlling naked short selling and derivatives trading. Naked short selling, where the investor sells shares short without confirming the availability of the stock, has been banned.
Investors will also be forced to disclose their short position in a firm to regulators if it exceeds 0.2%, and to the market as a whole if it crosses 0.5%. Investors will have to disclose short positions on sovereign bonds, even if the position was obtained using credit default swaps.
The ban on naked short selling by the European Commission will be enforced from July 2012 after approval from the European Parliament. Previously, the seller did not have to prove their ability to obtain the stock. According to todays proposal, in order to "to enter a short sale an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party to locate and reserve them for lending so that they are delivered by the settlement date [at the latest 4 days after the transaction]."
We dont have a problem with restricting naked short selling, says Kevin McNulty, CEO of the International Securities Lending Association. There is a mechanism in place right now where prime brokers supply availability feeds to their clients so they can see what is available to borrow, but the requirements now is that they have to reserve the shares in the market first, so there is a bit more formality before they can sell short we think that is unnecessary.
The ban effectively expands the decision taken by BaFin, the German financial regulator, to ban naked short selling of debt securities and financial companies in May 2010.
The 0.2% shorting threshold was also introduced to the German market by BaFin in March 2010. The regulator issued a decree stating that market participants must notify BaFin of net short-selling positions in selected financial stocks of a threshold of 0.2 % or more and publish the same of a threshold of 0.5 % or more.
The 0.5% disclosure ruling may harm market efficiency, according to McNulty. What we have observed through our members is that investors tend to sell short up to the threshold of public disclosure but wont go beyond. They do that because they dont want to signal their investment strategies. This artificially limits trading volumes in the market and that hurts efficiency.
The ban on naked short selling goes further than actions taken by U.S. regulators in 2009. In July 2009 Rule 204T, originally introduced in 2008, was made permanent in order to reduce the potential for abusive "naked" short selling in the securities market by requiring broker-dealers (rather than the seller) to purchase or borrow securities to deliver on a short sale.
The EU stopped short of banning short selling or credit default swaps. The International Monetary Fund published a report in August stating that there is little evidence on the effectiveness of short sales bans. The IMF report, published in response to the EU Commission consultation on short selling, said the ban did relatively little to support the targeted institutions underlying stock prices, and market efficiency and quality in fact deteriorated substantially following the introduction of the various bans.
The IMF report also stated that for sovereign CDS spreads, empirical evidence shows that a large proportion of the recent spread variation across advanced countries can be traced back to fundamentals. Hence, speculation, as would be caused or amplified by (naked) short sales seems to be of relatively minor importance.
Giles TurnerNews Editor