European Securities and Markets Authority 103 Rue de Grenelle Paris France. 15 March 2013

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1 UBS AG P.O. Box 8098 Zürich Public Policy EMEA Group Governmental Affairs Thomas Pohl Bahnhofstrasse 45 P.O. Box 8098 Zürich Tel Fax European Securities and Markets Authority 103 Rue de Grenelle Paris France 15 March 2013 Re: ESMA s Call for Evidence on the Evaluation of the Regulation (EU) 236/2012 of the European Parliament and of the Council on Short Selling and Certain Aspects of Credit Default Swaps Dear Sir/Madam, UBS would like to thank ESMA for the opportunity to comment on the evaluation of the Regulation (EU) 236/2012 of the European Parliament and of the Council on Short Selling and Certain Aspects of Credit Default Swaps. Please find attached our response to the Call for Evidence. We would be happy to discuss with you, in further detail, any comments you may have. Please do not hesitate to contact Thomas Pohl on Yours sincerely, UBS AG Thomas Pohl Managing Director Head of Executive and International Affairs Dr. Thomas Bischof Managing Director Head of Legislative & Regulatory Initiatives

2 UBS Response to the European Securities and Markets Authority s Call for Evidence on the evaluation of Regulation (EU) 236/2012 of the European Parliament and the Council on Short Selling and Certain Aspects of Credit Default Swaps INTRODUCTION UBS would like to thank the European Securities and Markets Authority (ESMA) for the opportunity to comment on the Call for Evidence on the evaluation of Regulation (EU) 236/2012 of the European Parliament and the Council on short selling and certain aspects of Credit Default Swaps (SSR). Please find below our response to the overall content, as well as the specific questions set out in the Paper. General comments The evaluation of the SSR suffers from one serious limitation the observation period of 4 months is too short a time period to gauge the firm specific and market impact. We have therefore highlighted our observations on the operation of the SSR to the extent possible and otherwise raised our concerns with the anticipated effect of SSR, its Implementing and Delegated Regulations and the ESMA Guidelines on the Market Making Exemption. Our first concern stems from the interpretation of the market making exemption in your latest Guidelines, in particular the trading venue membership requirement for both the hedging and hedged instrument. The Short Selling Regulation and Recital 26 in particular underscored the crucial role played by market makers in providing liquidity to a market. As stock markets are barely recovering from a prolonged stress period and sovereign debt markets are still under pressure, ESMA should exercise its best effort not to damage liquidity by framing the exemption with strict conditions that would prevent market makers from maintaining a continuous presence in OTC markets. The market making exemption should recognise that not all products are suitable for trading on Response from UBS Page 2 of 17

3 venue, a concept that is embedded in the latest review of the Market in Financial Instruments Directive. If more bespoke products that are necessary to hedge bespoke risks are disproportionately impacted by the operation of SSR, this will increase overall systemic risk as firms will either not be able to hedge at all or will have to use standardised listed instruments that will increase basis risk. Second, we call on ESMA to protect liquidity on the corporate bond markets. The unavailability of the market making exemption for hedging of corporate bonds would lead to a fundamental shift in the trading and execution of corporate bonds. The obligation to find a locate before a firm could enter into a short position in sovereign debt as a hedging instrument, would delay the execution of the corporate bond. This would inevitably affect the pricing of the bond as it is costly for the market maker to bear the risk of holding it while a suitable sovereign bond is located. Funding costs for corporates are likely to dramatically increase, the adverse effects of which will inevitably spread to the real economy. Third, the use of market making exemption should be extended for CVA hedging as it plays a crucial role in the management of counterparty credit risk and the centralisation of risk management. Sovereign CDS are frequently used to protect dealers against uncollateralised exposures in OTC transactions with European sovereigns. We also highlight that Basel III, and its proposed EU implementation in CRD IV, explicitly permits and gives capital benefit for hedging of CVA risk. We therefore consider that any restrictions on the hedging of CVA risk imposed by the SSR market making guidelines would undermine the legitimate operation of CRD IV and result in a disconnect between EU conduct and prudential requirements. Fourth, we remain deeply concerned, as highlighted in our response to your consultation on the draft guidelines in September 2012, about the unavailability of the exemption for legitimate market making activities in affected instruments on third country markets. We strongly believe that competent authorities should not reject applications made by third country entities market making on third country markets during the period until which the European Commission Response from UBS Page 3 of 17

4 publishes its third country equivalence decisions provided the other relevant criteria are satisfied. Should the third country in question subsequently be determined non-equivalent by the Commission, the competent authority would be able to withdraw the exemption but should do so with an appropriate notice period in order for the entity in question to adjust its business to be compliant with the additional SSR requirements that would become applicable in the absence of the exemption. Fifth, we are concerned that any interpretation of the market making exemption by ESMA will have a spill over effect on other EU legislation and national legislations that are relying on the Short Selling Regulation s definition (Italian FTT legislation for example). The adverse effect on market liquidity would deepen as a result. Specific Comments In the remainder of our response, we offer specific comments on the Transparency and Reporting Requirements (Q1-7), Restrictions on Short Selling of Shares and Sovereign Debt (Q8 and 9), Restrictions into Entering into Uncovered Sovereign CDS (Q15-18), Exemptions (Q22-24) and Intervention Powers and Emergency Measures (Q26 and 27). TRANSPARENCY AND REPORTING REQUIREMENTS Q1. Do you consider that the initial and incremental notification/publication thresholds for net short positions in shares and sovereign debt have been set at the correct levels? If not, what alternative thresholds would you suggest and why? In relation to shares, private notification to the relevant competent authority is required for short positions at or above 0.2% of the issued share capital of the company and each incremental 0.1% threshold crossed. Public disclosure is mandated for net short positions at or above 0.5% of the issued share capital of Response from UBS Page 4 of 17

5 the company and additional disclosures when a position reaches or falls below 0.1% increments above that level. In relation to sovereign debt, monetary thresholds for short positions in debt instruments of sovereign issuers are fixed every 3 months, which will trigger an initial notification to the relevant competent authority. Incremental notifications are required set at 50% of the initial amount. While we recognise the need for greater transparency to stem market abusive behaviour, we do not agree with the current reporting thresholds. We question the benefit of the low threshold and the use made by the competent authorities of the vast amount of daily short position reports, which is a costly exercise for market participants. Q2. What use are you currently making of information made available by competent authorities or the central website operated or supervised by the relevant competent authority on public disclosures of net short positions in shares? From a buy-side perspective, we are concerned with the potential adverse effect of the public disclosures on corporate meetings. Put simply, if buy side investors are trying to organize a corporate meeting with a firm where they hold a public short position, that firm would use the knowledge of the position to drive the content of the meeting or in the worst case, refuse to meet with us at all. We would like to highlight the importance of corporate meetings which generally underpin the investment decision-making process and help to form an unbiased view of the company. We are concerned that the public disclosures could distort the message we hear from companies, that this could have a detrimental effect on the trading decision and will ultimately impact the funds we invest in. From a sell-side standpoint, we understand that sector desks have made limited use of the disclosed information, as there is no centralized platform for storing and publishing the data, no uniform terminology of data terms and a general Response from UBS Page 5 of 17

6 inconsistency in the data quality. We would welcome the creation of a centralized platform that is able to take file feeds. Q3 If you had taken short positions in shares and sovereign debt before the Regulation applied, what impact have the notification/disclosure requirements had on your trading behaviour since 1 November 2012? Within the limited observation period since SSR became operationally effective, we have not seen any significant changes in our trading behaviour. This is primarily because a significant proportion of our trading involving short positions relates to market making activity for which we have a market making exemption. We are however currently very concerned with the narrow interpretation of the market making exemption in your latest Guidelines, as highlighted in our answer to Q22. Q4 Do you have any comments on the method of calculating net short positions in shares and sovereign debt (e.g. the requirement to duration adjust cash positions in sovereign debt)? The net short position in a share is calculated as a percentage of the issued share capital of the company. The definition of issued share capital includes all shares rather than just particular classes, which can make calculation of the denominator more difficult as it is not consistent with publicly available information. Therefore we would appreciate if the relevant information on issued share capital would be provided by the ESMA or national regulators on a centralised platform. Second, the hedging of non-listed funds causes erroneous short positions to appear as non-listed funds cannot be included for netting purposes. We believe that national regulators and the public would receive more meaningful data about the net short position of a legal entity, if it was allowed to net a long position in a non-listed fund with a short hedging position in shares. As for sovereign debt, the wording in SSR suggests that only short positions in sovereign debt are calculated on a duration adjusted basis and not derivatives. Response from UBS Page 6 of 17

7 Amalgamating the figures based on two different methods does not yield a meaningful result, especially as the denominator (the total debt in issue number that the local regulators produce) is duration adjusted. We believe that for competent authorities to receive meaningful positions, such derivatives should also be duration adjusted as well. Q5 What is your view of the decision to adjust the monetary trigger thresholds for reportable short positions in sovereign debt every three months? Is there an alternative you would favour and if so please explain why? We are concerned with the lack of transparency on figures reported to ESMA each month. We would welcome clarity on how the new sovereign debt issues are calculated, how the levels are calculated and components of the monetary thresholds. Q6 Do you consider that reporting mechanisms are operating efficiently? If not, explain why and how they could be improved. In our opinion, the reporting mechanism is not currently operating efficiently. At present, there is no standardised methodology between different regulators. Some countries use forms sent via and others use web portals. The registration process for many of the regulators did not allow us to register either multiple people or entities, or both. In the case of Denmark, Austria and Hungary, a Power of Attorney would be required to show the names of people who would be making notifications to them via their online tool this does not allow some members of our reporting team to submit information. Such a restriction is not imposed on our teams when reporting to other regulators such as the AMF, FSMA and CNMV. In Ireland, the regulator would not allow more than one contact person per entity which makes the submission of information problematic when the appointed person is on leave. We would urge ESMA to improve the reporting system through the creation of a centralised reporting platform, based on a standardised methodology and data Response from UBS Page 7 of 17

8 terminology, which is able to take file feeds. A single data reporting point is currently being considered via the various iterations of the draft MiFID II package, and we would welcome a similar approach taken under the Short Selling Regulation. A centralised reporting platform would allow us automate the process in turn. If a position crosses the public disclosure threshold, it would be automatically flagged as such. Furthermore, it is sometimes necessary to report on public holidays which is very difficult to comply with from an operational perspective a grace period of 1 day would address this issue. Q7 Do you have any other comments on the reporting and transparency requirements or on their operation since 1 November 2012? We would reiterate the comments made to Q6. In addition, we would like to highlight the fact that the need to make all disclosures on one day at the beginning of November significantly increased operational risk, especially as several relevant competent authorities had not organized their websites until 1 or 2 days beforehand. RESTRICTIONS ON SHORT SELLING OF SHARES AND SOVEREIGN DEBT Q8 Have you observed any improvements in settlement performance (either your own or that of counterparties) since the Regulation became applicable? We have noted a visible positive impact on settlement performance since the Regulation became applicable. Q9 Have you noticed any impact on the cost or availability of securities lending since the Regulation has applied? Please specify any effect you have seen. We note both an increase in cost and reduced availability of securities lending since the Regulation became effective. The restrictions have reduced the overall Response from UBS Page 8 of 17

9 supply, driving up costs. The increase in short duration and small size borrows to ensure adherence to the Regulation has led to a surge in the cost of our lending program. The transaction costs significantly outweigh the lending fee revenue. These costs need to be absorbed by borrowers or it will result in the cancellation of such a service. RESTRICTIONS ON ENTERING INTO UNCOVERED SOVEREIGN CREDIT DEFAULT SWAP POSITIONS Q15 Have you noticed any effect of the prohibition on entering into an uncovered sovereign CDS transaction on the price and on the volatility of the sovereign debt instruments? Under SSR, an uncovered position is one where the sovereign CDS does not serve to hedge against: (a). the risk of a default by the sovereign in whose debt the person has a long position and to which the sovereign CDS relates; or (b) b.the risk of decline of the value of the sovereign debt where the person holds assets or is subject to liabilities whose value is correlated to the value of the sovereign debt. There are alternative quantitative and qualitative tests for determining whether the assets/liabilities are correlated to the value of the sovereign debt. The size of the sovereign CDS position needs to be proportionate to the size of the exposures being hedged, subject to certain exceptions. Cross border hedging (use the sovereign CDS of one member state to hedge against the asset/liability of a different member state) may be permitted under certain circumstances. Since the application of the Short Selling Regulation in conjunction with other EU regulatory developments, we have observed an increase in prices for the EU sovereign debt instruments. However, there remains significant intraday volatility in these instruments. Response from UBS Page 9 of 17

10 Q16 Have any elements of the prohibition on entering into an uncovered sovereign CDS transaction had a noticeable effect on your ability to hedge your exposures? If yes, please quantify the impact and explain where the issue arises. The various elements of the prohibition have had a significant effect on our ability to hedge the exposures within an existing CDS portfolio. The liquidity in the CDS market has collapsed and bid offers have widened as volumes have gone rapidly down. CDS has become a worse hedge for sovereign debt exposure (the basis with cash remains volatile). Q17 Have the restrictions on entering into an uncovered sovereign CDS led you to use any alternative methods for hedging your exposures? If so, please elaborate. We have started to rely more on sovereign debt cash instruments as a hedge for CDS, despite the volatility in the correlation. Q18 Do you have any other comments on the requirements concerning uncovered sovereign CDS positions or on how they have operated since 1 November 2012? The ban on uncovered sovereign CDS has effectively removed a useful hedging tool used to reduce bank risk across a wide variety of products. We expect that risks have become more concentrated due to the ban on this product, and hence market dislocations may become more severe in any adverse scenario. Response from UBS Page 10 of 17

11 EXEMPTIONS Q22 Does the current definition and scope of the exemption for market making activities allow sufficiently for liquidity provision? We are deeply concerned with the narrow interpretation 1 of the market making exemption 2 in the latest ESMA Guidelines (ESMA/2013/158) and its potential adverse impact on market liquidity. Trading Venue Membership We understand that a pre-requisite for eligibility to the market making exemption is that the person be a member of a trading venue where it is conducting some market making (including hedging) on a specific financial instrument and it is also confirmed that such instrument must be admitted to trading or traded on that trading venue. In our view, the third hedging limb of the market making exemption is intended to enable market makers to continue offering liquidity in OTC products and to enable market participants to use these instruments, for instance, to effectively address customised hedging needs and effectively mitigate bespoke risks. We believe it is essential that the market making exemption recognises the different nature of markets for different products and enables: (i) significant market making activity to occur off trading venue for those instruments where there is only limited on venue trading and (ii) all trading to occur off trading venue for instruments that do not trade at all on venue. A considerable amount of market making activity in financial instruments within scope of the SSR, and where liquidity is provided, occurs away from 1 The ESMA Guidelines (ESMA/2013/158) stipulate that (i) the market making exemption applies on an instrument by instrument basis (ii) An entity intending to benefit from the exemption needs to be a member of a trading venue where it conducts some market making activities including hedging, on a specific financial instrument. It is also confirmed that the concerned instrument must be admitted to trading or traded on that trading venue. (iii) Exemption is only available for MM activities in third countries provided the other conditions are met and that the Commission has decided that the legal and supervisory framework of the country complies with legally binding requirements equivalent to those laid down by MiFID concerning regulated markets and by the Market Abuse and Transparency Directives. So far the Commission has not adopted such decisions 2 Market making exemption under SSR relates to the activities of an investment firm, a credit institution, a third-country entity, or a firm as referred to in point (l) of Article 2(1) of Directive 2004/39/EC (MiFID), which is a member of a trading venue or of a market in a third country, the legal and supervisory framework of which has been declared equivalent by the Commission pursuant to Article 17(2) where it deals as principal in a financial instrument, whether traded on or outside a trading venue, in any of the following capacities: (i) by posting firm, simultaneous two-way quotes of comparable size and at competitive prices, with the result of providing liquidity on a regular and ongoing basis to the market; (ii) as part of its usual business, by fulfilling orders initiated by clients or in response to clients requests to trade; (iii) by hedging positions arising from the fulfilment of tasks under (i) and (ii) Response from UBS Page 11 of 17

12 trading venues. In order to ensure that the Regulation operates effectively, the reference to dealing in a financial instrument must not be interpreted so that trading outside of such a venue is automatically regarded as activity not covered by the exemption. If the interpretation of ESMA is not revisited, it would have serious adverse repercussions on liquidity provisions as highlighted below. First, CDS are not admitted to trading venues in the EU but are traded OTC. The ESMA interpretation would exclude sovereign CDS from the market-making exemption and make it impossible to undertake market making in CDS whilst benefiting from the market-making exemption. As sovereign CDS are within the scope of the SSR as set out in Article 1, we do not consider the ESMA interpretation of the trading venue requirement to be compatible with the Level 1 text as it appears to effectively prevent any person using the market making exemption for sovereign CDS hedging despite this being explicitly contemplated by SSR Article 2, 1. (k). We also consider the ESMA proposal to be inconsistent with SSR recital (26) as it will inevitably result in a significant fall in liquidity in sovereign CDS and have a significant adverse impact on the efficiency of the Union market. Second, there is a potential impact on competition and end investors. Not all brokers or prime services firms are members of a trading venue, this is particularly true of smaller brokers and prime services firms. Consequently, the ESMA interpretation of the trading venue membership requirements will likely reduce the number of brokers or other firms that are able to make markets and will disproportionately affect smaller brokers and firms. We believe this will be detrimental to competition and diversity within the market and likely have the greatest negative impact on retail investors who are typically important users of such firms. Third, restricting the scope of the market making exemption is likely to lead to a reduction in secondary market liquidity which will disincentivise firms from acting in the capacity of authorised primary dealers. This is because, even if primary dealers benefit from the exemption provided for in the SSR, they require a liquid Response from UBS Page 12 of 17

13 secondary market as they cannot just trade instruments amongst themselves. This may result in reduction of primary dealer activity by firms (particularly in peripheral EU countries where existing liquidity is relatively low) with a consequent negative impact on sovereign debt financing by the relevant debt management offices. If secondary market liquidity dries up, primary dealers may choose not to bid on a new issuance if they are uncertain as to the depth of the secondary market. This may result in the issuance programme failing or yields increasing sharply which will undermine the ability of sovereigns to fund themselves via the capital markets. This has potential systemic implications. We further note that we would not support any interpretation of the market making exemption that is intended to force or encourage trading of certain OTC instruments onto trading venues. In our view, this is not the intention of the SSR Level 1 text and we do not consider that the SSR should be used for this purpose. Whilst we are supportive of a general move towards on venue trading for instruments that are sufficiently standardised and liquid, we strongly believe that the characteristics of certain financial instruments make them unsuitable for on-venue trading and that they should not be subject to mandatory onexchange trading. We also note the current review of MiFID covers this issue and whilst it proposes to expand the range of instruments subject to mandatory onvenue trading, several exemptions are proposed to this requirement to reflect the unsuitability of certain instruments and markets to on-venue trading. Hedging market making in corporate debt The ESMA Guidelines introduce an exhaustive list of instruments that can benefit from the market making exemption when hedged with short positions in securities provided both the hedged and hedging instruments are admitted to trading on a venue. We are very concerned that the hedging of market making in corporate bonds is not included in this list. It is common practice to use a sovereign debt instrument to hedge a corporate bond against the sovereign credit risk as well as fluctuations in interest rate. Losing the benefit of the market making exemption for the hedging of corporate bonds would have a high detrimental impact. If a corporate bond trader had to locate the sovereign bond Response from UBS Page 13 of 17

14 before executing each transaction, the market maker would simply have to increase the costs to the borrower for the risk it bears while negotiating the borrow or delay execution until the relevant sovereign debt is located. This would seriously impede the ability of our market makers to respond quickly to client orders and thereby reduce market liquidity. CVA Hedging Hedging entered into by a CVA desk can be for the purposes of hedging credit, market and close-out risk related to its market making activities. In our view, this type of hedging is permissible under the market making exemption in the Regulation, and is consistent with the intent of the Level 1 and 2 rules. Competent authorities could then review market making applications on a case by case basis and have the ability to reject any applications that seek to exempt any CVA hedging activity that does not relate to CVA risk generated by market making activity. The ability of financial institutions to manage counterparty credit risk in this way is of great importance to financial and economic systems. If financial institutions are prevented from managing such risks adequately, especially in times of economic and financial stress, they will be exposed to and experience mark-tomarket losses and hence broaden the systemic impact of any deterioration of a sovereign rather than reducing or containing it. We also highlight that Basel III, and its proposed EU implementation in CRD IV, explicitly permits and gives capital benefit for hedging of CVA risk. We therefore consider that any restrictions on the hedging of CVA risk imposed by the SSR market making guidelines would undermine the legitimate operation of CRD IV and result in a disconnect between EU conduct and prudential requirements. Response from UBS Page 14 of 17

15 Q24 Is the current unavailability of the exemption for market making activities in third country markets having any impact? We would like to differentiate between two separate cases: (i) third country firms making a market in a third country market and (ii) EU firms making a market in a third country market. With respect to (i), until the Commission makes a positive equivalence declaration on a third country s legal and supervisory framework, third country firms engaging in legitimate market making activities in affected instruments on third country markets will not receive the exemption. To date, we understand that no third country jurisdiction has been deemed equivalent or even assessed for equivalence by the European Commission for the purposes of SSR. As a result, third country entities making a market on a third country market in instruments within scope of the SSR would have to incur operational expenses to report net short positions on a daily basis, comply with the locate requirements before entering into a short sale of shares and sovereign debt and respect the ban on uncovered sovereign CDS, even if they are making a market in such instruments in a manner consistent with the interpretation in ESMA s guidelines. They will also not be able to enter into legitimate hedging strategies, as permitted by Article 2(1)(k)(iii) of SSR, to manage the risk from their market making activity. The absence of a positive equivalence assessment therefore has a clear detrimental impact on third country firms, their clients and market liquidity. To remedy this situation in the immediate future, we recommend the following pragmatic solution. Competent authorities should not reject applications made by third country entities market making on third country markets during the period until which the European Commission publishes its third country equivalence decisions. We believe such applications should not be rejected by competent authorities in the absence of positive equivalence determinations, provided the other relevant criteria are satisfied. Should the third country in question subsequently be determined non-equivalent by the Commission, the competent authority would be able to withdraw the exemption but should do so with an appropriate notice period in order for the entity in question to adjust its Response from UBS Page 15 of 17

16 business to be compliant with the additional SSR requirements that would become applicable in the absence of the exemption. With respect to (ii), we believe that it would not facilitate the acceptance of extraterritoriality of EU law in foreign jurisdictions if EU law provided for more favourable treatment of EU incorporated firms via-a-vis third country firms. The current guidelines imply that EU firms can rely on the market making exemption even if making a market in a third country. Third country firms making a market on the very same trading venue would, however, be restricted from relying on such an exemption due to the fact that the Commission had not (yet) declared that specific third country equivalent. This could have a material impact on competition in third countries, creating an unlevel playing field in these third country markets, which third country authorities are likely to consider unacceptable. This situation is aggravated by Article 16 of the Regulation, according to which the short selling regime could apply to securities that are considered to have their primary listing in a third country, provided that their principal trading venue is in the EU. INTERVENTION POWERS AND EMERGENCY MEASURES Q26 What is your assessment of the effect of temporary restrictions imposed by competent authorities on short selling since the application of the Regulation? Please explain Our experience is that temporary short selling bans increase volatility, especially when communicated at the last minute by competent authorities. The support they do provide to the stocks is short term. At a procedural level, we would welcome a single platform for communicating these restrictions using a standard template that clearly defines what is / is not in scope. We found significant differences between competent authorities on the recent bans (e.g. in the recent Spanish ban, ETFs and Indexes had to be decomposed into their underlying constituents, whereas in Italy they did not). A Response from UBS Page 16 of 17

17 uniform template used to publish this temporary restriction would help to dispel any confusion. Q27 In case of emergency bans, a) is the information to be published according to Art. 25 of the Regulation sufficient? b) If no, please explain what other/additional information should be provided when introducing an emergency measure. We are very concerned with the different approaches taken by different regulators in the recent past to the temporary ban in short selling for the same stock. For example, in the case of Saipem, the Italian regulator banned all short selling conducted on the Italian MTA market, but stated that the prohibition did not apply to market making activity. Later in the same trading day, the UK FSA banned short selling in Saipem on all UK trading venues and did not allow a market making exemption. These individual temporary bans were released to the market at different times in the trading day and on each individual regulator s website. Such dissemination of information is not efficient and results in confusion in the market. b) If no, please explain what other/additional information should be provided when introducing an emergency measure Temporary short selling bans should apply equally across jurisdictions that choose to implement them. Reiterating our comments made to Q26, the temporary bans should be announced by regulators in a co-ordinated manner, preferably on a centralised website/rns feed. Alternatively, national regulators/esma should operate an alert function that would allow firms to receive an alert when temporary short selling bans come into effect in any jurisdiction. Response from UBS Page 17 of 17