I am writing in response to the statement issued by the Financial Services Authority (FSA) on 13 June. Our comments concern the new disclosure regime which comes into effect tomorrow and the suggestion in your notice that you are considering further measures, including restricting the lending of stock of securities in rights issues for the purposes of enabling short selling.
ISLA does not object to disclosure of short positions in principle. But we remain unclear what urgent need prompted the introduction of this disclosure regime without consultation or reasonable notice. We object to the introduction of disclosure requirements as part of the market abuse regime and with the apparent presumption that taking large short positions in rights issues shares is potential market abuse. In our opinion, any disclosure regime for short positions should be part of the more neutral disclosure and transparency rules.
We welcome the sentence in your statement that ‘the FSA regards short selling as a legitimate technique which assists liquidity and is not itself abusive’. That is consistent with the conclusions of your thorough and thoughtful review of short selling in 2002 which found that short selling is a ‘legitimate investment activity which plays an important role in supporting efficient markets…Hence we see no case for prohibiting short selling…and the introduction of specific regulatory constraintswould not be warranted’.
But, against that background, it is unclear to us why you believe, ‘there is increased potential for market abuse through short selling during rights issues’ nor how, ‘the rights issue process provides greater scope for what might amount to market abuse, particularly in current conditions’ nor why you believe that, ‘severe volatility in the shares of companies conducting rights issues’ can be attributed to short selling (as opposed to underlying uncertainty about the fundamental value of the companies concerned). Our analysis of the CREST data on lending of HBoS shares during the current rights issue period, for example, does not suggest any significant increased demand to borrow the shares. There was some increase in demand to borrow RBS shares during its recent rights issue period but not at a time when the share price fell significantly (see appended charts).
We appreciate that you may have evidence of genuine market manipulation that is not available to the wider public or evident in this data. It would be helpful to understand, by way of worked examples, in what circumstances you would regard short selling of rights issue shares, of itself, as market manipulation? For example, it would be helpful to include the cases of (i) a directional short position in the shares taken before the rights issue on the basis of fundamental analysis; (ii) a directional short position in the shares taken after the rights issue on the basis of fundamental analysis; and (iii) a short position in the shares taken to hedge, or partially hedge, a long position in the rights.
We feel that the need to understand the FSA’s reasoning behind the hurried implementation is especially important for two reasons:
(1) Under the Financial Services and Markets Act, the FSA has a duty to consult and to conduct a cost: benefit analysis before making such changes to the Code of Market Conduct. We understand that you have relied on the provisions allowing immediate amendments in cases of ‘urgent need’ where delay would be ‘prejudicial to consumers’, particularly small investors. We think you have an obligation to explain what makes the need urgent in this case and why delay would be prejudicial to consumers. This is something that our members have not seen previously and the concern is that it is a precedent for the future.
(2) The implication of your notice is that any person that does disclose a short position of greater than 0.25% in a rights issue share may be under suspicion of market abuse. As things stand, we believe that this will act as a deterrent to taking such positions, for whatever purpose. In our opinion, supported by academic studies on this subject, the market for these shares will therefore become less efficient. We also fear that the announcement of any new rights issue could now prompt a sudden closing out of short positions in that stock, possibly leading to a temporary and artificial increase in the share price.
Finally, we understand that the EU Market Abuse Directive Level 3 is under review and we would like to know whether you expect any changes to the wider EU regime in the light of the new FSA rules.
Following the meeting you held with representatives of trade association and firms on Monday and the Q&A published on Tuesday afternoon, it is now clearer how the new regime will work. However, given the timeline from the initial announcement and the clarification on Tuesday, most firms will have had insufficient time to prepare. We understand that the FSA are unwilling to grant waivers from compliance with the new regime. We do, nonetheless, request some forbearance in the early stages at least given the lack of time to establish reporting systems.
We are grateful to the FSA for publishing an initial list of securities that it knows to be part of this regime. We request that you update this list regularly. Many firms will only be advised by their agents of rights issues if they have a position in the security at the time of announcement. Where a position is entered into after that date, no subsequent notification will be received. Publishing a list would ensure that all firms are reporting on the correct companies and remove any ambiguity around what needs to be reported.
Finally, we remain unclear how options positions should be reported: can you confirm urgently whether it should be on the basis of the notional or the delta please?
You indicated that this was not a firm proposal and we would strongly urge you to reconsider the idea and at the very least invite consultation from the industry before taking any action.
We do not believe it is possible for a lender of shares or its agent to be sure of the purpose for which those shares are being lent. Lenders deal with banks and dealers, which usually borrow through a single desk for many purposes, including covering market making positions, for clients and for settlement. Title is necessarily transferred to the borrower and the lender cannot track the future movements of those shares, potentially through a number of subsequent borrowers or outright purchasers. In practice, lenders would have to assume that any lending might enable short selling and therefore cease all lending of right issue shares.
Restricting lending would deprive investment institutions, mostly UK-based, of legitimate securities lending income.
Liquidity in single-stock derivatives, such as contracts for difference and options, would be similarly curtailed if dealers were unable to hedge long positions by selling the physical shares short. In the large-capitalisation shares, reduced securities lending would have an impact on index derivatives and exchange-traded funds. For example, arbitrage traders would be unable to buy the FTSE-100 futures contract and sell the underlying securities without a liquid securities borrowing market in all the major constituent shares. As a result, the FTSE-100 future would be priced less efficiently and its liquidity would fall.
Settlement fails would also increase if dealers were unable to borrow securities in order to settle their obligations.
Most importantly, taking away the ability to borrow shares would damage liquidity in the cash equity and related derivatives markets. Dealers would be less willing to provide liquidity to customers by purchasing their shares if they were unable to hedge by borrowing the shares in order to enter into a short position. Trading costs would be likely to rise.
We look forward to hearing from you on the points we raise and would be happy to discuss any of these points further or provide further information if you wish. Given the wide interest in this issue, we intend to publish this letter on our website.
Yours sincerely,
David RuleChief ExecutiveInternational Securities Lending Association