The European Securities and Markets Authority (ESMA) was urged by the US hedge fund industry to provide clarifying guidance on aspects of the recently approved EU Regulation restricting transactions in short sales and credit default swaps. The Regulation, (2010) 0482, is intended to harmonize the rules on short selling and credit default swaps and thereby ensure that the EU internal financial market functions correctly. ESMA is the pan-European securities regulator.
In a letter to ESMA, the Managed Funds Association asked ESMA to provide examples, for purposes of the restriction on uncovered sovereign credit default swaps, in which the value of a particular portfolio of assets is correlated to the value of the particular sovereign debt, and adopt clear requirements for investors and other market participants to locate shares prior to engaging in a short sale. In addition, the MFA requested that the Regulation include convertible bonds in the calculation of a net short position. The letter was signed by Richard H. Baker, MFA CEO, and former Chair of the House Capital Markets Subcommittee.
Article 3(3) of the Regulation requires that any position held by a person indirectly, including through an index or basket of securities, must be included in the calculation of short and long positions. The association noted that Article 3(3) refers to the position holder having regard to publicly available information as to the composition of the index or basket. The MFA urged ESMA to clarify that publicly available information means information that can be obtained without payment so that position holders do not have to pay significant fees to index owners for data licenses.
Otherwise, said the MFA, it would be extremely expensive for market participants to include broad-based indices in their calculations. Typically, trades on indices are used for hedging purposes rather than to take a directional view on a particular name on the index, so market participants do not currently track the detailed information in relation to underlying stock in an index.
The MFA is especially concerned about the practical effect of requiring disaggregation of all positions in indices. Unlike existing short selling disclosure rules that apply mainly to financial institutions, the disclosure obligation under the Regulation applies to all companies admitted to trading in the EU. This means, said the MFA, that the reporting burden will be significantly greater than is currently the case under the existing regime.
This is particularly problematic in relation to broad-based indices. In this regard, the MFA believes that Article 3(3) should be interpreted such that a position in an index should be considered only if an individual stock represents more than a certain percentage, such as 20 percent, of the index, or the position holder through its holding in the index holds more than 1 percent of the relevant stock. This approach is used, for example, by the UK Financial Services Authority in its existing rules on the disclosure by holders of long positions. The FSA rule includes an anti-avoidance provision so that a person could not utilize this approach in order to avoid having to make the relevant notification.
The MFA also believes that a person calculating a net short position should be permitted to net long positions held by means of convertible bonds against short positions in the same issuer. Excluding convertible bond positions, reasoned the MFA, would mean excluding what is legitimately a long position from the calculation and giving an inaccurate result. The MFA noted that the definition of “issued share capital” in the Regulation refers to the total of ordinary and any preference shares issued by the company, but does not include convertible debt securities.
Thus, the definition does not exclude convertible bonds from the calculation of long positions under Article 3(2) of the Regulation, reasoned the MFA, it simply states which of the issuer’s securities should be aggregated to determine the denominator of the calculation of a person’s net short position. Thus, the association urged ESMA and the European Commission to clarify that investors should include long positions through convertible bonds in the calculation.
The MFA also posited that, when calculating long and short positions for purposes of the disclosure obligation, investment managers should be permitted (but not required) to aggregate the positions of funds managed by them where appropriate, such as for funds which adopt similar investment strategies. Noting that the broad definition of “sovereign goes beyond a reference simply to each EU Member State, the MFA sought the clarity of a specific list of entities which are considered to be sovereign issuers for purposes of the Regulation; with such a list to be published on the ESMA website. Importantly, the MFA urges that financial instruments be accounted for on a delta-adjusted basis rather than a notional basis, which more accurately reflects the relevant person’s economic exposure to the underlying shares and is consistent with existing short selling rules.
Uncovered Positions in Credit Default Swaps
The main issue raised by Article 4 of the Regulation is whether for purposes of the restriction on uncovered sovereign credit default swaps in Article 14 the value of a particular portfolio of assets or financial obligations is correlated to the value of the particular sovereign debt so that one could show that the credit default swap was entered into to hedge an exposure. The MFA encouraged ESMA to take a broad view of correlation, recognizing that correlation can be present in a wide range of circumstances.
The MFA also asked the EU regulators not to impose a strict requirement for the sovereign credit default swap protection buyer to hold the exposure it is hedging for the life of the swap. This is important, explained the MFA, because under English law and New York law, which together govern the majority of credit default swaps, a requirement that a credit default swap protection buyer always hold the reference obligation could result in that swap contract being characterized as a contract of insurance.
This would result in the protection seller being required to have a license to write insurance, noted the MFA, adding that protection sellers in most cases do not have such licenses. The MFA urged ESMA to clarify that the reference to “insurable interest” principle should be taken as merely indicative of the policy behind the rule in Article 14 of the Regulation, rather than an expression of what the rule requires.
Consistent with the insurance recharacterization issue, the MFA asked that there be no strict requirement for a sovereign credit default swap to be unwound upon the protection buyer no longer holding the reference asset, provided that the protection buyer entered into the swap contract in good faith with the intent of holding the asset for a reasonable period of time and hence was hedging an exposure. In addition, a protection buyer under a sovereign credit default swap should have the flexibility to reallocate the hedge to another asset by redesignating what the relevant swap covers for purposes of Article 4 of the Regulation.