Monday, February 20, 2012

Hedge Fund Industry Comments on ESMA Proposed Standards under EU Short Selling Directive

In a letter to the European Securities and Markets Authority, the Managed Funds Association urged ESMA to provide additional flexibility in the technical standards implementing the EU Regulation restricting transactions in short sales and credit default swaps. The Regulation, (2010) 0482, was approved recently and will be immediately and directly applicable in all Member States from November 1, 2012, with no possibility for Member State regulators to interpret or implement the Regulation in a way which fits local circumstances. With that in mind, the MFA asked that ESMA be given time to consult with market participants on the issues and seek additional relevant data, such as the frequency of settlement fails for short sales. The letter was signed by former US Rep. and House Capital Markets Subcommittee Chair Richard Baker, who is currently MFA President.

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. 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 its comments, the MFA accepted that, in the case of shares, information on the exact percentage of holding and equivalent number of shares would provide competent authorities with useful information as well as an opportunity to conduct checks on the accuracy of calculations. In this regard, MFA broadly agrees with the format of the net short position fields in the Notification Form for Net Short Positions annexed to the draft technical standards.

However, the MFA believes that, for the purposes of public disclosure, the net short position size should be rounded down to one decimal place rather than two, as suggested in the draft. This approach would follow the language and the legislative intent of Article 6 of the Regulation more closely. The thresholds contained in Article 6 are expressed in one decimal point format, said the hedge fund association, which indicates that the legislative intent was to monitor the variations of 0.1% and not positions in between. ESMA did not identify any public policy reasons as to why disclosure of position in two decimal point format would be preferable. Thus, the MFA believes that it would be disproportionate for ESMA to require public disclosure in that format.

The MFA agreed that there should be one standard form for public disclosure of information on significant net short position in shares. Similarly, the association agreed that there should be one standard format for notifying relevant competent authority for each type of instrument.

The MFA is concerned with the binary nature of the assessment of whether a share is a “liquid share” and thus whether it falls within the Standard Same Day Locate Confirmation and Measures or the Liquid Shares Locate Confirmation and Measures. In the MFA’s view, these should be collapsed into what is currently proposed to be the Liquid Shares Locate Confirmation and Measures, but with a different name to remove the reference to Liquid Shares.

In addition, the MFA believes that the proposed definition of a “liquid share” from the Market in Financial Instruments Directive (MiFID) would not be appropriate in the context of locate arrangements. The liquid shares concept in MiFID was introduced for the purposes of pre- and post-trade transparency, such as provisions relating to disclosure of firm quotes in liquid shares and publication of share turnover statistics. In the context of short sale transactions and the trading of securities in general, however, what may be considered to be liquid can change from day to day. For example, a share that may be liquid under the MiFID definition may in fact be extremely illiquid at the time of the short sale transaction due to a merger announcement or other corporate event.

As a practical matter, reasoned the MFA, the approach that a locate provider uses, such as a prime broker in relation to a hedge fund, is fundamentally the same regardless of liquidity of the relevant shares. There is no simple line that can be drawn between liquid shares and illiquid shares; instead, there is a spectrum with liquid shares at one end, then hard to borrow shares and finally extremely hard to borrow shares at the other end.

A useful indicator of where the share falls in that spectrum is the cost that the locate provider charges the investor for the locate, which reflects the cost of borrowing such shares from other parties in order for the locate provider to satisfy its obligation to the investor. The MFA believes that the locate provider should make the assessment of the relative liquidity or illiquidity of shares available to it, to settle an investor’s sale, whenever it provides a locate to an investor. In doing so, the locate provider should have regard to the relevant criteria, including the cost that the locate provider is charging the investor and the daily sources of supply of such shares available.