Wednesday, March 14, 2012

Hedge Fund Industry Comments to ESMA on EU Short Selling and Credit Default Swap Regulation

As the European Securities and Markets Authority readies guidance on the EU Regulation on Short Selling and Credit Default Swaps, the hedge fund industry has issued detailed comments on many aspects of the proposed guidance. In a letter to ESMA, the Managed Funds Association notes that the definition of “sovereign issuer” in the Regulation is broad in that it goes beyond a simple reference to each EU Member State.

In order to provide clarity to the financial markets, the MFA believes that there will need to be a specific list of entities which are considered to be sovereign issuers for purposes of the Regulation; such a list could be published, for example, on the ESMA website. In this regard MFA welcomes the statements made by ESMA during the February 29, 2012 hearing on the Consultation Paper that ESMA would be publishing such a list, in accordance with its proposals for the thresholds to be applied for reporting net short positions in sovereign debt issuers.

In relation to the calculation of long positions in shares for purposes of the net short position calculation, the MFA believes that an investor should be permitted to net long positions held in convertible bonds against short positions in the same issuer. Excluding convertible bond positions would exclude a legitimate long position from the calculation and give an inaccurate result, reasoned the MFA, both to regulators and to the public. Separately, subjecting investors to the disclosure requirements under Articles 5 and 6 of the Regulation on the basis that they are unable to net off long convertible bond positions from their short positions in the same company would discourage investors from subscribing to convertible bond issues by such companies.

The MFA also noted that the definition of “issued share capital” under the Regulation refers to the total of ordinary and any preference shares issued by the company but does not include convertible debt securities. The MFA believes that the definition should not be interpreted to mean that long positions held in convertible bonds are to be excluded from the calculation of long positions under Article 3(2) of the Regulation. Rather, the definition is simply describing the universe of the issuer’s securities that should be aggregated to determine the denominator of the calculation of a person’s net short position.

Article 3(2) of the Regulation refers to long positions relating to the issued share capital of a company. Convertible bonds are long positions which “relate to” the issued share capital of a company, said the MFA. The Regulation does not define “share” and it is open to ESMA and the Commission to determine that “share” includes convertible bonds. The MFA urged ESMA to recommend that the Commission determine that convertible bonds may be considered to be “shares” for purposes of Article 3(2).

The MFA said it is extremely important that convertible bonds should at the very least be included in the calculation for purposes of short selling bans, whatever approach might be taken in relation to the calculation of net short positions for the purposes of the disclosure requirements under Articles 5 and 6. The recognition of convertible bonds in the calculation of net short positions was recognized pre-regulation in some existing Member State short selling bans, including those imposed by France and Italy in the latter half of 2011. The MFA urged ESMA to clarify that, in the context of prohibitions on short selling, convertible bonds can be included in determining whether a person has a short position in an issuer which is a subject of the prohibition.

The MFA agrees with the approach taken by ESMA that financial instruments should be accounted for on a delta-adjusted basis rather than a notional basis. This more accurately reflects the relevant person’s economic exposure to the underlying shares.

Separately, the MFA urged ESMA to distinguish between broad-based indices and narrow-based indices. Positions in broad-based indices are typically taken for hedging purposes, noted the MFA, and not as a directional view on a particular name in the index. Thus, the MFA reasoned that an investor with a long or short position in a broad-based index should not be considered as having a long or short position in the underlying shares. Positions in broad-based indices do not confer a financial advantage in the event of an increase or decrease in the value of the underlying shares for the purposes of Article 3(1)(b) and (2)(b).

ESMA was also urged to consider the sensitivity adjusted method to calculate short positions. In the MFA’s view, this method would be consistent with the current market practice for valuation of bonds. Trading in sovereign bonds often is not concerned with credit quality, noted the MFA, but more focused on macroeconomic factors, such as inflation expectations or the impact of currency values, and yields of sovereign debt.

It is also very important, emphasized the MFA, that there should not be 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 because under English law and New York law, which together govern the majority of credit default swaps, a requirement that a CDS protection buyer always hold the reference obligation could result in that CDS contract being characterized as a contract of insurance. This would result in the protection seller being required to have a license to write insurance. In this regard, the MFA asked ESMA to clarify that the reference to “insurable interest” principle in Recital (21) 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.

Further, ESMA should clarify in its advice that a protection buyer may reallocate a hedge to another asset, at any time, by redesignating what the relevant CDS covers for purposes of Article 4 of the Regulation.

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