Reflections on short selling regulation in the European Union

1. Reflections on short selling regulation in the European Union Francois-Serge Lhabitant and Jeannine Daniel

2. Reading Questions • What is short selling? • Does a short sellers’ activity amplify the fall of security prices below fundamental values? • Were the emergency measures by respective European Governments to restrict or impose disclosure requirements effective? • Would a more harmonious and uniform approach to short selling regulation be more effective? • What are the advantages of a more ‘even playing field’? • What are the key takeaways from the Porsche versus VW Case Study? • Is short selling possible in Eastern Europe? If so, which regions is it possible and which areas is it more difficult and why? • Which Eastern European Country adopted a different approach to the short selling regulation?

3. Short selling Short selling is the market practice of selling a security that the seller does not own at the time of the transaction. In order to deliver it to the buyer, the seller therefore has to borrow the security, with the aim of buying it back later at a lower price to return it to the lender.

4. September 2008 in Focus S&P 500 in September 2008 MSCI Europe Financials Index September 2008 was a momentous month for not only European, but global markets, a period which saw the decline of both US and European large scale financial institutions, rapid de-leveraging of global financial intermediaries, a spike in short term financing costs, runs on banks, fierce selling of commodities and related investment themes, as well as a “crisis of confidence” in markets and regulatory authorities in general. In response, unprecedented levels of regulatory intervention became an almost daily affair, as authorities around the world announced various initiatives to help stem widespread panic, as investor confidence was tested and a flight from asset markets in general escalated.

5. The impact of regulation • The financial sector globally experienced an extremely volatile month in July 2008 as the U.S. government was first to act to assist a handful of financial institutions. On July 15th, amidst a sharp market sell-off and extreme levels of fear in the marketplace, the SEC issued an emergency order to curb the naked short selling of nineteen major financial institutions, in order to prevent substantial disruption in the securities markets. European Countries followed in the SEC footsteps over the next few months announcing a similar handful of temporary regulations on financial related and in some cases, a broader list of stocks. • The SEC ruling signaled to the market that the U.S. government was willing to establish a safety net for the nineteen financial institutions on the list. As a result, investor confidence was boosted. Not only did the shares of the nineteen companies referred to in the bill appreciate by an average of 25.3% between July 15th and July 31st, but the broader financial sector (as measured by the S&P Financial Sector Index) also rallied 24.6% over the same period.

6. Porsche versus VW Porsche structured its options as ‘cash settled,’ as BaFin, Germany's financial regulator, ruled that companies were not obliged to disclose positions where the derivatives were settled into cash rather than shares Thus, Porsche’s actions were not transparent to market participants and, therefore, the resulting impact on VW’s stock price was significant given just 5.8% free float. This resulted in a very painful period for those hedge fund managers positioned as short the stock. Supply and demand imbalances and mark to market losses put pressure on managers to buy back the stock to cover their position, usually at the same time leading to upward pressure on the company’s share price and large losses for those hedge funds who assumed short positions. VW briefly traded at levels which made it the largest company in the world, ahead of Exxon, and, in a relative sense, the company was larger than the remaining U.S. and European automotive companies, combined. Interestingly on December 31st 2010 a U.S. judge dismissed the lawsuit by 10 hedge funds accusing Porsche of cornering the market for VW shares which resulted in $2bn of damages. Porsche stock surged 14.1% on January 3rd in response to the news.

7. Shorting in Eastern Europe Source: Citi

8. Shorting in Eastern Europe • In the case of Turkey and Poland note that when shorting the indices are heavily weighted towards banks and utilities. • Almost 30% of the WIG 20 Index is split between two bank names. • 40% of the ISE 30 Index is split between three bank names.

9. The European Commission’s draft regulation • To ban naked short sales in equity securities. Short sales will only be permitted if the seller has borrowed the security, entered into an agreement to borrow it, or made other arrangements to ensure that the security has been located and reserved for lending. • To increase transparency and disclosure standards for short positions in shares traded on a European exchange or trading facility. • To establish adequate processes and give regulators the powers to restrict short selling entirely, limit entries into CDS transactions relating to an obligation of a Member State, or require additional private notification or public disclosure in exceptional circumstances. • To establish buy-in procedures and daily fines for late settlement of transactions. Regulated markets must also prohibit those who have failed to settle in the past from entering into further trades. This clause, in addition to the ban on naked short selling, should help reduce counterparty risk, another risk which could potentially undermine the stability of the financial system. • To exempt market makers acting in their capacity as such in a uniform way across Europe. • To establish the European Securities and Markets Authority (ESMA) as a central Paris-based authority to take and/or coordinate short selling measures in exceptional situations. Its potential benefits are a reduction of legal costs associated with individual regulations (either directly or indirectly as a result of decreased confusion among market participants), significant time saving for the legal body for each jurisdiction, less room for regulatory arbitrage and more confidence against uncertainty for market participants. It is this confidence which is core to ensuring the stability of the financial system. 9

10. Conclusion • The temporary measures imposed by individual European Governments to restrict or impose disclosure requirements on short selling were effective in terms of stabilising the volatile price impact on stocks in the banking sector which reduced ‘panic button’ selling. • However…a more holistic approach to regulation is generally agreed to be beneficial to member states as it will help reduce uncertainty created by the piecemeal rules. • Is expected to result in a more efficient allocation of resources, namely time and cost. A blanket regulation should allow for lower legal and transaction costs. • We should expect the regulation to evolve over time to allow for adjustments in the exogenous landscape (e.g. Sovereign CDS). • The Porsche versus VW Case Study highlights the potential impact of regulation loopholes and the effect of ‘market surprises’ which can result when there is little or no disclosure transparency. • For liquidity reasons the ability to short in various Eastern European jurisdictions is limited, and hence short selling regulation is less relevant in certain jurisdictions. • Turkey and Poland are the more developed Eastern European markets. Short selling in Kazakhstan, Slovakia, Latvia, Estonia, Romania and Slovenia is much more difficult. • Poland decided to permit naked short selling, albeit within a regulated framework.