Acting to provide uniformity across the EU, the European Parliament approved a Regulation restricting transactions in short sales and credit default swaps. The Regulation, (2010) 0482, notes that at the height of the financial crisis authorities in several EU Member States and other countries such as the United States and Japan adopted emergency measures to restrict or ban short selling in some or all securities. They acted due to concerns that at a time of considerable financial instability, short selling could aggravate the downward spiral in the prices of shares, notably in financial institutions, in a way which could ultimately threaten their viability and create systemic risks.
The measures adopted by Member States were divergent as the Union has lacked a common regulatory framework for dealing with short selling. The Regulation is intended to harmonize the rules on short selling and credit default swaps and thereby ensure that the EU internal financial market functions correctly. Internal Market Commissioner Michel Barnier praised the adoption of the Regulation, especially noting that the work of the rapporteur Pascal Canfin, who strengthened the text.
The Regulation addresses only restrictions on short selling and credit default swaps to prevent a disorderly decline in the price of a financial instrument, and does not address the need for other types of restrictions such as position limits or restrictions on products.
Under the Regulation, a person may only enter into a short sale of a share admitted to trading on a trading venue where one of the following three conditions is met. First, the person has borrowed the share or has made alternative provisions resulting in a similar legal effect. Second, the person has entered into an agreement to borrow the share or has another absolutely enforceable claim to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due. Third, the person has an arrangement with a third party under which that third party has confirmed that the share has been located and has taken measures vis-à-vis third parties necessary for the person to have a reasonable expectation that settlement can be effected when it is due.
In order to ensure uniform conditions of application, ESMA is directed to draft regulations determining the types of agreements and measures that adequately ensure that the shares will be available for settlement. In determining what measures are necessary to have a reasonable expectation that settlement can be effected when it is due, ESMA must take into account, among other things,, the intraday trading and the liquidity of the shares. ESMA must submit the draft implementing these standards to the European Commission by March 31, 2012.
The Regulation imposes similar restrictions on uncovered short sales in sovereign debt. However, the restrictions do not apply if the transaction serves to hedge a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the given sovereign debt.
Similarly, the Regulation imposes restrictions on uncovered credit default swaps in sovereign debt. Thus a person may enter into credit default swap transactions relating to an obligation of a sovereign issuer only where that transaction does not lead to an uncovered position in a credit default swap.
For purposes of the Regulation, a person will be considered to have an uncovered position in a sovereign credit default swap when the swap does not serve to hedge against the risk of default of the issuer when the person has a long position in the sovereign debt of that issuer to which the sovereign credit default swap relates; or the risk of a decline of the value of the sovereign debt where the person holds assets or is subject to liabilities, including but not limited to financial contracts, a portfolio of assets or financial obligations the value of which is correlated to the value of the sovereign debt.
A competent authority may temporarily suspend the restrictions when it believes, on the basis of objective elements, that its sovereign debt market is not functioning properly and that the restrictions might have a negative impact on the sovereign credit default swap market, especially by increasing the cost of borrowing for sovereign issuers or affecting the sovereign issuers' ability to issue new debt.
These objective elements must be based on the following non-exclusive indicators: high or rising interest rate on the sovereign debt, widening of interest rate spreads on the sovereign debt compared to the sovereign debt of other issuers, widening of the sovereign credit default swap spreads compared to other sovereign issuers, timeliness of the return of the price of the sovereign debt to its original equilibrium after a large trade; and amounts of sovereign debt that can be traded.
The Regulation also states that a central counterparty providing clearing services for shares must ensure that, when a person who sells shares is not able to deliver the shares for settlement within four business days after the day on which settlement is due, procedures are automatically triggered for the buy-in of the shares to ensure delivery for settlement. Similarly, when the buy-in of the shares for delivery is not possible, there must be procedures ensuring that an amount is paid to the buyer based on the value of the shares to be delivered at the delivery date, plus an amount for losses incurred by the buyer as a result of the settlement failure.
Also, the Regulation requires the central counterparty to have procedures ensuring that a person who sells shares fails to deliver the shares for settlement by the date on which settlement is due will be subject to the obligation to make daily payments for each day that the failure continues. The daily payments must be sufficiently high to act as a deterrent to failing to settle.