UK FSA Seeks Input on Proposed Short Selling Disclosure Requirement

The below post is compliments of my esteemed colleague John Filar Atwood

The U.K. Financial Services Authority has proposed a general short selling disclosure requirement in a discussion paper that asks market participants for their input on the international debate on short sales. The FSA stopped short of providing a detailed blueprint for a disclosure regime because it believes a global consensus on the issue must be developed. The regulator simply wants to contribute to the work already being done by IOSCO, CESR and others on short selling.

The FSA stated in no uncertain terms that it believes that short selling is still a legitimate trading activity that tends to enhance price efficiency and liquidity. It also believes that there should be no direct restrictions on short selling. However, the regulator does see advantages in having enhanced transparency of short selling, and so proposed that disclosure requirements for significant short positions should be introduced for all U.K. listed stocks.

The FSA acknowledged that the different disclosure measures on short selling taken by various regulators around the world have raised issues for those firms that operate cross-border. It hopes that any enhanced transparency requirements for short selling would be applied on as wide a basis as possible to avoid market participants having to cope with a multiplicity of regimes.

Short selling can be used to commit market abuse and can contribute to disorderly markets, the FSA noted, and it understands that short selling is viewed as a controversial technique by many, particularly in times of falling markets. There is a widespread conceptual problem with market participants being able to sell something they do not own, according to the FSA, but economic theory and empirical studies support the view that short selling normally contributes to the efficient functioning of the market.

The FSA said that the case for improving transparency of short selling is two-fold: it would provide additional valuable information to the market, and applying new disclosure obligations could mitigate some of the problems associated with short selling.

A disclosure obligation enhances transparency by disclosing to the market the size of significant short positions and the identity of significant short sellers in the relevant stocks. This provides insight into short sellers’ price movement expectations and can improve pricing efficiency if the information is correctly interpreted, the FSA said. More information about the opinions that investors hold on a particular stock would be available to all investors.

A requirement to disclose short positions held also would help in detecting short selling that is being used to commit market abuse, in the FSA’s opinion. Greater transparency through disclosure also could help identify when investors are over-reacting to abrupt price changes, and give the regulator more advance warning of conditions in which it might have to consider regulatory intervention.

In the discussion paper, the FSA also outlined the potential costs of adding new disclosure obligations. If any new transparency obligations have the effect of significantly reducing the overall level of short selling, this could have an impact on price formation and liquidity in general. In addition, if short sellers adjust their behavior to stay under any disclosure limits, this would reduce the overall informational benefits.

The FSA noted that depending on how disclosures are made, another indirect cost could be the possible herding effect of other short sellers following a big-name short seller. This has the potential to turn a downward price spiral into a self-fulfilling prophecy, according to the FSA. This may also occur with the publication of information about the level of aggregate short interest in a particular stock.

There are also the direct costs to firms that conduct short selling—staff hours spent on compliance, funds needed to set up and maintain disclosure systems—in implementing and operating the systems in order to comply with new obligations. The FSA noted that these would be magnified if firms were faced with different obligations in different jurisdictions.

Even with these costs, the FSA said that because markets operate normally for the vast majority of time, it is firmly of the view that the positive benefits of short selling outweigh the negative impacts. This is why the regulator did not propose a permanent blanket ban.

Although the FSA currently does not think that any direct constraints on short selling are justified, it acknowledged that extreme market conditions could re-emerge where the risks posed by short selling would warrant some form of emergency intervention, most likely in the form of a prohibition. The regulator promised to continue to monitor the markets and reintroduce a prohibition should it be warranted.