Prohibition and transparency rules

Like the current German short selling provisions, regulation of short selling in Europe is essentially based on two pillars: on prohibiting provisions for uncovered short sales and certain transactions in credit default swaps (CDSs), as well as on transparency provisions for net short positions. As with the regulations in Germany, exemptions are also provided here for the activities of market makers. Moreover, it will also be possible in future for primary dealers to use the exemption.

Regulation governing short selling in Europe is set out in the EU Short Selling Regulation and in four implementing regulations clarifying the provisions of the EU Short Selling Regulation: a Delegated Regulation, inter alia with regard to definitions (Delegated Act – DA), an Implementing Regulation laying down implementing technical standards (ITS), and two Delegated Regulations with regard to Regulatory Technical Standards – RTS of 29 June 2012 and RTS of 5 July 2012). These interpreting rules were prepared by a working group of ESMA made up of representatives from the supervisory authorities of the EU Member States. The European Commission published the interpreting rules – partly in amended form – in June and July 2012.⁽¹⁾

Financial instruments included

Unlike the German provisions, the new European provisions cover not only those shares admitted on the regulated market in Germany but also shares admitted and/or listed on regulated markets and multilateral trading facilities (MTFs) (Article 2(1) of the EU Short Selling Regulation).

That significantly broadens the scope of application, since now shares listed on the regulated unofficial market (Freiverkehr) may also be subject to the transparency and prohibiting provisions. That said, the shares in question must be "European" shares, i.e. shares having their principal venue for trading within the EU. ESMA has published a list of such exempted shares on its website. This lists the shares which, whilst being traded on an MTF or a regulated market in the EU, do not fall under the prohibiting and transparency provisions because their turnover for the most part originates from countries outside Europe (Article 16(2) sentence 2 of the EU Short Selling Regulation).

Like the German rules, the provisions of the EU Short Selling Regulation are also applicable outside the EU and to natural or legal persons from third countries. In this regard it does not matter where the transaction in question is concluded nor what nationality the involved parties have nor where they have their registered office.

The scope of application also changes for sovereign debt instruments, for which admission to a regulated market is not longer required. Instead, the only decisive thing is for the sovereign debt to be issued by an EU Member State, the Union or other sovereign issuers (Article 2(1d) of the EU Short Selling Regulation). Unlike the existing provisions, sovereign debt instruments of local authorities no longer fall under the scope of application.

Prohibition of uncovered short sales

Like the existing rules under German legislation, the EU Short Selling Regulation sets out three prohibiting provisions: for uncovered short sales in shares, for sovereign debt and for uncovered sovereign credit default swaps (Article 12 et seq. of the EU Short Selling Regulation). The prohibitions are distinguished from the existing German provisions only in terms of their scope of application and the regulatory rules.

For example, the prohibitions are more stringent given that now the decisive time for assessing an uncovered short sale is the conclusion of the transaction. That means that providing coverage for the short sale only by the end of the trading date (intraday exemption) is no longer allowed.

Uncovered short sales in shares

A short sale is allowed only if at the time of the short sale one of the coverage options provided by Article 12(1a)-(1c) of the EU Short Selling Regulation has been used. The prerequisite for this is that the transaction is capable of being settled when due.

Articles 5 to 8 of the ITS define which types of agreements, arrangements and measures adequately ensure that a share will be available for settlement of the transaction. Pursuant to Article 5 of the ITS, agreements to borrow and other enforceable claims must be entered into prior to or at the same time as the short sale, provide for physical settlement of the securities and specify a delivery or expiration date that ensures that the short sold securities are available for settlement on time. These conditions are satisfied in certain cases e.g. by futures, options and repos.

Pursuant to Article 6 of the ITS there are several possibilities of satisfying the minimum conditions to be met by the locate arrangement of a third party. Which requirements apply depends on whether a locate arrangement is required only for the day of the short sale or for a longer period. Generally, a standard locate arrangement is to be concluded prior to the short sale. The locate arrangement must include a locate confirmation and a put on hold confirmation (Article 6(2) of the ITS). If the standard locate arrangement is aimed solely at a coverage on the day of the short sale (same day locate arragements), facilitated requirements apply. This is possible e.g. where the shares by which the short sale is to be settled originate from another transaction. Pursuant to Article 6(4) of the ITS, facilitated requirements also apply to locate arrangements for liquid shares.

Uncovered short sales in sovereign debt

The prohibition of uncovered short sales in sovereign debt pursuant to Article 13 of the EU Short Selling Regulation is similar to the prohibition of uncovered short sales in shares. Similar conditions have to be satisfied, particularly with regard to coverage. The requirements for locate arrangements are further defined in Article 7 of the ITS.

However, this prohibition, unlike the prohibition on short sales in shares, may be suspended by the competent national authority for up to twelve months if it has negative effects on the liquidity of the sovereign debt (Article 13(3) of the EU Short Selling Regulation in conjunction with Article 22 of the DA).

Uncovered sovereign credit default swaps

As under the existing German rules, it will not be allowed in future to enter into uncovered sovereign credit default swaps. In the event of the market for sovereign debt being disrupted, this prohibition may likewise be temporarily suspended (Article 14 of the EU Short Selling Regulation).

A credit default swap (CDS) is covered if the collateral taker holds a long position in a debt instrument of the reference entity and by means of the CDS wishes to hedge the default risk of the sovereign issuer. The CDS is also covered if it hedges a risk of a decline in value of a sovereign debt instrument and the collateral taker holds assets or has liabilities that are correlated with the sovereign debt instrument (Article 4(1) of the EU Short Selling Regulation in conjunction with Article 14 of the DA). Such correlation is measured on the basis of qualitative and quantitative criteria (Article 18 of the DA). In this connection Article 15 of the DA defines cases in which it may suffice for the CDS and the sovereign bond not to refer to the same Member State.

Transparency requirements for net short positions

Like German law, the EU Short Selling Regulation lays down transparency requirements for shares. In contrast to the existing rules, however, transparency requirements in future will also apply to sovereign debt, and, subject to certain conditions, to CDSs.

The purpose of notifications of net short positions is to provide the competent authorities as well as ESMA (to which certain notifications and positions are forwarded by the national authorities on a quarterly basis) with an overview of the short positions that are potentially relevant by reason of their size.

Two-tier transparency system for shares

The European rules continue the two-tier transparency system for shares already existing in Germany in section 30i of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG). In the event of a net short position reaching or falling below the relevant thresholds, such position, as already required under German law, must be notified to the competent national authority and, where applicable, published (Article 5(1) and (2) of the EU Short Selling Regulation). In Germany, persons or entities subject to the notification requirement must effect publication in the Federal Gazette (Bundesanzeiger).

Single-tier transparency system for sovereign debt

A new element is the single-tier transparency system for net short positions in sovereign debt (Article 7(1) of the EU Short Selling Regulation). Unlike the transparency requirements for shares, sovereign debt instruments are subject only to a requirement for notification and not publication. The competent authority for notifications of net short positions in debt instruments of the German government or the German federal states is BaFin.

The content of the notification is nearly identical to the content of the notification for a net short position in shares. However, the net short position is not required to be stated as a percentage but as a specific monetary amount. The sovereign issuers are assigned two initial percentage thresholds which are based on the total amount of outstanding issued sovereign debt and the liquidity for the respective futures market (Article 21 of the DA). The current aggregate amount of sovereign debt issued by each Member State is published quarterly by ESMA (Article 7(2) sentence 2 of the EU Short Selling Regulation).

Germany is assigned to the category of countries with a 0.5 per cent threshold, whereas the German federal states fall under the first category with a threshold of 0.1 per cent. The initial thresholds of 0.1 per cent are followed by additional supplementing reporting thresholds at intervals of 0.05 per cent starting at 0.15 per cent. The initial threshold of 0.5 per cent is followed by the supplementing reporting thresholds at intervals of 0.25 per cent starting at 0.75 per cent.

Transparency system for sovereign credit default swaps

Notification of uncovered positions in sovereign credit default swaps is required only if a supervisory authority suspends the restrictions on uncovered CDSs pursuant to Article 14(2) of the EU Short Selling Regulation (Article 8 of the EU Short Selling Regulation). The respective reporting thresholds are then equal to the thresholds for net short positions in the respective sovereign debt instruments.

Calculation of net short positions

As before, the relevant time for calculating the net short positions is at midnight at the end of a trading day (Article 9(2) of the EU Short Selling Regulation). Notifications and, where applicable, publications in future must be submitted not later than 3.30 p.m. on the following trading day. The time in the Member State whose authority has to be notified of the relevant position is decisive.

As before, the calculation of net short positions in shares must include all financial instruments held by the respective holder, such as exchange traded funds (ETFs) or futures. For shares, the requirement for the calculation to use the delta of the financial instruments at the end of the trading day continues to apply. What is new is that financial instruments based on shares or debt instruments not yet issued, such as subscription rights, in future will be included in the calculation at least on the long side (Article 7 sentence 1b of the DA).

Net short positions in sovereign debt are to be calculated according to the nominal value duration adjusted (Annex 2 to Article 11(1) of the DA). The duration formula to use is the Modified Duration. The current requirements are based on changes made by the European Commission to the original proposal of the ESMA working group for the Delegated Regulation (inter alia with regard to definitions). In the case of sovereign debt, long positions in debt instruments of other sovereign issuers that are highly correlated with sovereign debt may also be included in the calculation (Article 3(5) of the EU Short Selling Regulation in conjunction with Article 8(5) and (6) of the DA).

Calculation in funds, portfolios as well as groups

The calculation in groups and fund structures as well as the related reporting requirements will be more complicated compared with the existing German provisions.

If several funds or portfolios are managed by one management entity, the net short position is initially calculated at the level of each individual fund or portfolio according to the general rules. The existing net short positions are not notified individually for the funds but are initially aggregated depending on the investment strategy of the management entity. The investment strategy may, pursuant to Article 12(2a) of the DA, be oriented towards a net short position or a net long position of the respective fund. In the second step, net short positions with the same investment strategy are aggregated at the level of the management entity. This total net short position must be notified to the competent authority and, if applicable, published. If the management activity is delegated to an external third party, the latter aggregates its net short positions of the same investment strategy (Article 3(7) sentence 2 of the EU Short Selling Regulation in conjunction with Article 12 of the DA).

For groups, a different calculation method applies (Article 3(7) sentence 2 of the EU Short Selling Regulation in conjunction with Article 13 of the DA). Here, too, the net short positions are initially calculated at the level of each individual legal entity according to the general provisions. However, the positions are then aggregated at the level of the group irrespective of the investment strategies of the companies (net short or net long position).

A further difference versus the managed funds is that the transparency requirements must be satisfied at both levels. That means that, as a general rule, both each individual legal entity and the group must notify and, where applicable, publish the net short position separately – with the group doing so in aggregated form. However, this does not apply if an aggregated net short position subject to the notification requirement exists at the group level. In such case only one legal entity specified by the group notifies the aggregated net short position and publishes the same where applicable. This prevents positions being counted twice, i.e. both the positions which are published for the market participants and those positions which are notified only to the supervisory authorities.

Exemption rules for market makers and primary dealers

Exemptions from the prohibitions on short selling and the transparency requirements exist for market making activities as well as for activities of a primary dealer in sovereign debt (Article 17(1) and (3) of the EU Short Selling Regulation). As a prerequisite for the exemption, the activity must be notified to the competent authority and the respective transaction must be rendered as part of a market maker activity.

Currently, market makers are required to notify the inclusion of additional securities in their activity without undue delay after the end of a quarter, namely as at the last day of the quarter. In future it will be required to notify the activity in a certain financial instrument 30 calendar days before the exemption is used. In an ESMA working group, representatives of the national supervisory authorities have drafted a Guideline for Market Making which was recently in the consultation phase. Publication of the Guideline is expected to take place in the middle of 2013. On its website, BaFin has published a Guidance Notice containing instructions on how market makers and primary dealers are to prepare their notifications until then.

EU Short Selling Implementing Act

As an EU Regulation, the EU Short Selling Regulation is binding and has immediate effect. It thus does not have to be transposed into national legislation. The German EU Short Selling Implementing Act (EU-Leerverkaufs-Ausführungsgesetz), which has been in the draft stage since March 2012, will therefore supersede all national short selling provisions in the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG).

Section 30h of the WpHG (new version) sets out the powers of BaFin for monitoring the EU Short Selling Regulation and provides for a power to issue statutory instruments for new German regulations, such as a new German Regulation on Net Short Positions (Netto-Leerverkaufspositionsverordnung – NLPosV). Moreover, the new Act adjusts the existing sanctioning rules, as well as the obligations to report suspected violations pursuant to section 10 of the WpHG, to the new provisions without involving any substantive changes.

(1) Some of these rules, which the European Commission published on 29 June and 5 July 2012, are not yet binding.