Short Selling: A Brief Overview and Regulatory Update


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Short Selling: A Brief Overview and Regulatory Update

  2. 2. Short Selling Executive Summary Short selling is a strategy used by investors to balance portfolio allocations and manage risk. It also performs a number of important roles in the marketplace – aiding with price discovery and providing much-needed liquidity. This presentation offers a brief overview of short selling, the benefits it provides for investors and the marketplace and how it is regulated in the United States and European Union. Contents Executive Summary 2 What is Short Selling? 3 How Does Short Selling Work? 5 The Benefits of Short Selling 6 How is Short Selling Regulated in the US? 7 SEC Regulation SHO 8 European Short Selling Regulations 10 Short Selling Regulation in the EU 12 Effects of Short Selling Bans 13 MFA Advocacy 16 References 17 2
  3. 3. What is Short Selling? What is Short Selling? Short selling is a trading strategy fund managers employ when they believe that shares of a particular stock are overpriced. It generally means borrowing a security (or commodity futures contract) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. The short seller closes out the short position by purchasing equivalent securities on the open market, or by using an equivalent security it already owned, and returning the borrowed security to the lender. Short selling can be used to profit from an expected downward price movement, to provide liquidity, or to hedge the risk of a long position in the same security or in a related security. Source: . 3
  4. 4. What is Short Selling? Types of Short Selling In covered short selling, the investor has made arrangements to either borrow the securities or to ensure that they can be borrowed to perform the transaction. A naked short sale is one in which the investor does not own the securities at the time of the sale and has not made arrangements to borrow them in time to make delivery to the buyer within the standard three-day settlement period. 4
  5. 5. How Does Short Selling Work? 100 SHARES XYZ = $2500 VALUE Mr. Doe is worried about XYZ Co’s upcoming earnings report, however, and decides to offset this long position by selling short ABC Inc. stock - which is in the same market sector as XYZ Co. and would likely also lose value should XYZ report poor earnings. BORROW 100 shares ABC @$25/share John Doe holds 100 shares of XYZ Co. - valued at $25 per share – as a long investment position. Mr. Doe makes arrangements to borrow 100 shares of ABC Inc. stock at $25 per share and immediately sells it in the marketplace netting $2,500. Mr. Doe must return the borrowed shares at a specified date. SELL 100 borrowed shares ABC @$25 PROFIT FROM SALE of ABC shares = $2500 As anticipated, the earnings report is negative and XYZ Co. and ABC Inc. stocks both decrease in value to $20 per share. Mr. Doe buys back the quantity of ABC Inc. stock needed to cover his short position (100 shares at $20 per share for a total cost of $2,000). BUY 100 shares ABC@$20 RETURN 100 shares ABC to lender COST TO PURCHASE 100 shares ABC @$20 = $2000 Mr. Doe has earned a profit of $500 on the short sale and offset the decrease in value of the long position held in XYZ Co. LOSS on100 shares XYZ = PROFIT from short sale of ABC shares = -$500 $500 5
  6. 6. The Benefits of Short Selling Why do Investors Engage in Short Selling? The ability to quickly blend positive and negative information into share prices is essential for markets to work efficiently. Short selling provides the following benefits in the marketplace:* • • • • • • • * Increased liquidity Increased capital formation Improved price discovery, which bolsters investor confidence Decreased transaction costs (e.g. smaller bid-ask spreads) Decreased occurrences of price bubbles and / or crashes Efficient risk allocation Hedging against long term investment positions 6 SEC Securities Lending and Short-Selling Roundtable : 9/29/09-9/30/09
  7. 7. How is Short Selling Regulated in the US? Short Selling Regulations in the U.S.: The SEC is the government agency tasked with regulating securities markets in the U.S. Throughout the years, they have developed and implemented various regulations related to short selling, including Regulation SHO, which was finalized on August 6, 2004 and has been supplemented in recent years. Regulation SHO was adopted under the Securities Exchange Act of 1934 to meet the following goals, according to the SEC: • Establishing uniform “locate” and “close-out” requirements to address problems associated with failures to deliver, including “potentially abusive ‘naked’ short selling.” • Creating “uniform order marking requirements” for all equity securities sales, requiring participants to label orders placed with broker-dealers as “long,” “short,” or “short exempt.” Source: 7
  8. 8. SEC REGULATION SHO Regulation SHO applies to short sales of equity securities and includes the following key components: Locate Requirement “Close-out” Requirement Regulation SHO requires a broker-dealer to have “reasonable grounds” to believe the specified security can be borrowed so that it can be delivered on the due date before executing a short sale. Broker-dealers are required to document the ‘location’ before making the transaction. Broker-dealers must close-out any outstanding failure-to-deliver positions (“open-fails”) by the settlement day, following the settlement date. 8
  9. 9. SEC REGULATION SHO Regulation SHO has been amended since implementation in 2005 to include new rules governing short selling: Rule 201 Known as the “alternative uptick rule,” Rule 201 was approved in February 2010 as an amendment to Regulation SHO. The rule includes a “short sale-related circuit breaker,” which is triggered when a security’s price declines by 10 percent or more in a day. Once triggered, short selling of that security is only permitted if the price is above the current national best bid. Rule 201 applies to all equity securities listed on a national securities exchange, regardless of whether they are traded in an exchange or over-the-counter markets. Rule 204 In July 2009, The SEC amended Regulation SHO to include Rule 204 to reduce fails-to-deliver and curb abusive “naked” short selling. The SEC developed this rule in response to persistent “fails to deliver” in the marketplace, penalizing firms if they do not close out fails in a timely fashion. Short Sale Data Several self-regulatory organizations (SROs) provide daily aggregate short selling volume in formation on their websites and on a one-month delayed basis – including information on individual short sale transactions. 9
  10. 10. European Short Selling Regulations European Union and Member State Regulations: European nations traditionally regulated short selling individually, rather than collectively through the European Union (EU). For example, during the financial crisis in 2008, several EU member states implemented independent emergency measures restricting or banning short selling. As a result, the European Commission released a proposed regulation in September 2010 related to short selling and certain aspects of credit default swaps (CDS). The proposal introduced common requirements and powers to harmonize regulation across EU member states. After months of negotiations in the European Parliament, the Council of the European Union and European Commission agreed to a final text in October 2011. It was signed on Wednesday, March 14, 2012. 10
  11. 11. European Short Selling Regulations European Union and Member State Regulations: • Short selling regulation was signed on Wednesday, March 14, 2012. • The European Securities and Markets Authority (ESMA) developed is draft advice, and presented it to the European Commission on April 20, 2012. • The European Commission adopted its final delegated acts and regulatory technical standards on July 5, 2012. • The Regulation took effect on November 1, 2012. 11
  12. 12. SHORT SELLING REGULATION IN THE EU The new regulation covers a number of items1, including: Reporting & Disclosure Location Transparency & Restrictions The regulation requires reporting of net short positions to regulators over a certain threshold, and public disclosure of net short positions over a higher threshold The regulation further requires parties entering into a short sale to have borrowed the instruments, entered into an agreement to borrow them or made arrangements with a third party under which that third party has confirmed that the share has been located. The regulation also provides competent authorities with temporary power to require greater transparency or impose certain restrictions on short selling in emergency situations. 12 1 The regulation also imposes restrictions on EU sovereign CDS, which are not covered in these materials. More information on EU short selling regulation can be found here.
  13. 13. Effects of Short Selling Bans US and UK Short Selling Bans & the Financial Crisis: During the height of the financial crisis, several international regulators put in place emergency measures to restrict the short selling of various financial companies and other securities. In September 2008, the U.S. SEC issued an Order Halting Short Selling of certain financial securities in an attempt to “restore equilibrium to the markets.” The SEC acted in conjunction with the UK’s Financial Services Authority (FSA), which instituted a similar ban. The ban further deteriorated investor confidence in financial securities and was followed by steep selling by institutional investors that owned financial securities.* Up until the SEC Order Halting Short Selling of certain financial securities, the restricted financial securities were actually performing better than the market.** The chairman of the SEC at the time publically stated that, in retrospect, it was the “biggest mistake” of his tenure.*** **The Managed Funds Association, Comment Letter to Jean-Pierre Jouyet, pp. 2, August 13, 2011. Managed Funds Association, Comment Letter to Steve Maijoor, pp. 2, August 14, 2011. *”Why Banning Short-Selling Doesn’t Do Any Good.” August 12, 2011. **The 13
  14. 14. Effects of Short Selling Bans SEC Short Selling Ban Subsequent studies show that the SEC Order Halting Short Selling did not prevent price declines, but severely degraded the market quality of the subject securities as it: • • Failed to stop the steep price declines (see chart below , from study by Oliver Wyman,* on stock declines during the U.S. and UK short sale bans – noted in gray); Increased volatility; • Impaired capital raising for the subject securities; • Decreased market efficiency; • Significantly decreased trading volume and market liquidity; and • Increased bid-ask spreads from a ―normal average of 17 basis points in 2008 to 60 basis points by October 8, 2008. *”"The effects of short-selling public disclosure regimes on equity markets,“ Oliver Wyman, pp. 7. Funds Association, Comment Letter to Jochen Sanio, August 13, 2011, pp. 2. **”Why Banning Short-Selling Doesn’t Do Any Good.” August 12, 2011. **Managed 14
  15. 15. Effects of Short Selling Bans Short Selling and the European Debt Crisis: A number of EU member states took regulatory action in 2011 attempting to reduce market volatility resulting from the sovereign debt crisis. France, Italy, Spain and Belgium instituted temporary bans on short selling in August 2011. The bans were lifted in February 2012. The International Organization of Securities Commissions (IOSCO) later issued a report titled “The Credit Default Swap Market Report,” questioning the role short selling played in CDS or sovereign bond spread volatility. The report states among the conclusions: "To date, there is no conclusive evidence on whether taking short positions on credit risk through naked CDS is harmful for distressed firms or high-yield sovereign bonds.“ *The Credit Default Swap Market Report, Says Jury out on CDS Short Selling Impact - Reuters **”Watchdog 15
  16. 16. MFA Advocacy Managed Funds Association is constantly monitoring the financial and regulatory landscape and communicating with agencies responsible for rulemaking. MFA believes short selling plays an important, constructive role in the financial marketplace and that evidence shows short selling bans have proven to be more harmful than beneficial to financial markets. Specifically past experience with short selling restrictions show that: • Restrictions are counterproductive, further deteriorate investor confidence and increase volatility. • Restrictions impair the ability of investors to manage risk, which may lead investors to sell additional securities to balance their portfolios. • Restrictions harm the ability of financial institutions to raise capital through convertible bond and convertible preferred security issuances by preventing - or making it difficult for - investors to hedge the risk with offsetting short sales.* ”Letter to ESMA on EU Competent Authorities and ESMA Restricting or Banning Short Selling – Managed Funds Association 16
  17. 17. References U.S. Regulatory Agencies: Securities and Exchange Commission (SEC) European Resources: 1. European Commission 2. Council of the European Union 3. European Parliament 4. European Securities and Market Authority (ESMA) 5. Financial Services Authority (UK) MANAGED FUNDS ASSOCIATION Additional Resources: International Organization of Securities Commissions Managed Funds Association @MFAUpdates 17