European Commission. Public Consultation on Short Selling

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1 European Commission Public Consultation on Short Selling 9 July 2010 We are pleased to respond to the Commission's consultation. Here are some introductory comments: We do not believe that the concern about short selling risks is warranted; but... We believe that disclosure regimes are vital to monitoring and maintaining orderly markets; and that a more uniform and pervasive system of reporting should be introduced, which would decrease the complexity and risk of selective, partial and discriminatory reporting. Discriminating against short sellers is bad for liquidity, bad for fairness and unlikely to provide any benefits for the markets. The biggest risk is the one we don't know about yet. So simply collecting information about the perceived risks of the past is not adequate. Regulators cannot make good decisions without good information. In order to apply new or creative analysis techniques to market data, as well as historical comparisons, broad information is needed even if it is not immediately used. CDS instruments have been harshly vilified. However, the effective exposure is very similar to a short position, but without the administrative complexity of borrowing stock. This demonstrates that it is perfectly possible to have orderly markets with short sales in the absence of physical delivery. And the perceived risk: "...that a buyer of protection can have an interest in trying to bring about a default..." is no greater than any other short sale. Nothing in this correspondence should be construed as investment advice, an offer to buy or sell or a solicitation of an offer to buy or sell any investments or financial instruments or to participate in any particular trading strategy. Nevertheless, this document may not be distributed in any jurisdiction in any way which would violate applicable laws or regulations. The markets or financial instruments discussed may not be suitable for all investors and investors must make their own investment decisions using their own independent advisors as they believe necessary and based upon their specific financial situations and investment objectives. Investment Quotient ("IQ") has have taken reasonable care to ensure that statements of fact and opinion contained within this document are fair and accurate in all material respects, but such accuracy cannot be guaranteed. Nor will IQ be bound to update the document should new information arise or our opinions change. The use of this information by any party for any purpose whatsoever shall be entirely at such party s risk. IQ does not accept any liability whatsoever for such use and no claims for loss or damage arising from reliance on the information by any party shall be entertained. All rights reserved. No part of the publication may be reproduced, stored in a retrieval system or transmitted in any form by any means electronic, photographic, or otherwise without the prior permission of the copyright holder.

2 Consultation questions A: SCOPE 1. Which financial instruments give rise to risks of short selling and what is the evidence of those risks? Financial instruments do not give rise to risks themselves; it is misuse or inadvertent concentration that gives rise to risks. As such, all financial instruments should be treated equally. Short positions do involve more risk than long positions due to the asymmetric return profile; and some financial instruments carry more inherent leverage than others, or are typically used with more leverage. This brings us back to the point about use and misuse of the instruments. There are, however, grounds to say that instruments related to systemically sensitive organisations, such as banks and governments can be vulnerable to the expression of lack of confidence through selling these instruments. Thus far, the evidence seems to be that concerns leading to ordinary and short sales of bank shares, CDO, CDS and certain European countries' sovereign debt have been entirely founded in fact, rather than market abuse. For example, we know now that banks genuinely had diabolical balance sheets and excessive leverage, many self-certified loans were fraudulent, and some government finances were significantly worse than had been previously thought. So the key areas of concern can be demonstrated to have been NOT abusive. And in fact, the majority of selling behaviour in stressed moments can be attributed to conventional investors making covered sales, as witnessed by the continuing relentless selling after short sales of financial stocks was banned in the middle of the crisis, and the fact that Greek sovereign CDS is such a small part of the market, and the price falls in fact lagged the real market. This is actually evidence that investments typically used in short sales pose less risk than other instruments. 2. What is your preferred option regarding the scope of instruments to which measures should be applied? Exposure can take many forms, and individual instruments and positions may tell a misleadingly narrow picture. So we suggest that any measures be applied across the whole market. Consequently, Option "A" is more appropriate; however, it should also be adapted to include all OTC instruments that are current or yet to be invented, including a regime to apply standardisation (such as ISDA specification) to products yet to be invented. 3. In what circumstances should measures apply to transactions carried on outside the European Union? Managers or funds regulated in the EU should be required to report transactions outside the EU to home regulators. This will avoid the risk of abuse from the non-geographic nature of many markets. With information sharing across global regulators, global systemic risk can be reduced. 2

3 B: TRANSPARENCY 4. What is your preferred option in relation to the scope of financial instruments to which the transparency requirements should apply? Option A is less vulnerable to excessive complexity from derivative products which may have underlying exposure. For example, a long exposure to an instrument or fund could carry a short exposure to something else. That is not to say that it would be easy to calculate the underlying exposure; just that it would be possible. Whereas without having asked for the data, it would not. 5. Under Option A is it proportionate to apply transparency requirements to all types of instruments that can be subject to short selling? Transparency to the regulator is very important, and there is little argument against it for all instruments; transparency to the market is less so. In fact, arguably, such disclosure can lead to herding and disorderly markets. 6. Under Option B do you agree with the proposals for notification to regulators and the markets of significant net short positions in EU shares? Long positions in EU shares are disclosed to the market solely for takeover purposes. We do not believe that there are any grounds to disclose specific short positions to the market in anything other than aggregate anonymised format. 7. In relation to Option B do you agree with the proposals for notification to regulators of net short positions in EU sovereign debt (including through the use of CDS)? In addition to notification to regulators should there be public disclosure of significant short positions? As for other instruments, it is preferred to give full disclosure to regulators, and for public disclosure to be aggregated. However, with Sovereign debt, the systemic risks from inadvertent disorder or even excessively fast market efficiency could require treatment as a special case. 8. Do you agree with the methods of notification and disclosure suggested? Yes. 9. If transparency is required for short positions relating to sovereign bonds, should there be an exemption for primary market activities or market making activities? No. If market making activities are conducted with a minimum of risk taking, then the effect will be irrelevant; and if the market making is a cover for risk-taking hedge fund-type behaviour, then it should be disclosed anyway. This may become academic, considering the trend of thinking inherent in the Volcker rule; but for now, European "market making" banks still take on considerable market risk. In relation to primary market activities, it is especially important not to have different treatment, given the potential for anomalous messages from an underwriter who is selling in the market to hedge positions he is going to have to take onto its books. This happened somewhat notoriously when hedge funds were blamed for selling HBOS, when in fact it was underwriting banks 1 hedging their prospective exposures prior to the rights issue

4 10. What is the likely costs and impact of the different options on the functioning of financial markets? The cost of a simple copy of universal trade information is fairly low, as it can follow generally accepted existing protocols such as FIX, and pre-existing daily routines such as reporting to an administrator. However, a more finely defined and filtered disclosure regime is much more costly to implement, and may lead to attempts to circumvent it with creative use of instruments. C: UNCOVERED SHORT SALES 11. What are the risks of uncovered short selling and what is the evidence of those risks? If naked short selling is associated with a propensity to fail to deliver instruments for settlement, then there is a market disorder problem, but this is not a systemic issue. The problem can be easily enforced by serious sanctions on individuals or firms who fail to deliver, rather than a blanket ban which punishes market participants who are not causing disorder. Short selling, whether covered or uncovered, has been identified with encouraging efficient markets. However participants on the sharp end of short sales, such as corporate managers or governments who end up with tougher financing terms as a result of lower prices often blame the short sellers rather than look to the reasons the short sellers took the positions. Generally, other investors in the market are either agnostic because if the short sellers are wrong, then the price reverts, or they like short sellers because of the stock borrowing fees. However, since short sellers are often right, they are seen as the messengers, disclosing wrongdoing by corporate managers or governments. During the recent periods of market stress, the concept of risk from short selling was largely refuted by: the lack of effect of a short selling ban, and the price lagging behaviour of (uncovered) Greek sovereign CDS. 12. Is there evidence of risks of uncovered short sales for financial instruments other than shares (e.g. bonds or sovereign bonds), which would justify extending the requirements to these instruments? The same issues in question 11 apply here. However the bigger question, alluded to in our answer to question 7, is whether there should be special treatment for disclosure and restrictions for these instruments. 13. Do you agree with the proposed rule setting out conditions for uncovered short selling? Do you consider that more stringent conditions could be put in place? If so please indicate which ones? Do you agree that arrangements other than formal agreements to borrow should be permitted if they ensure the shares are available for borrowing at settlement? If so, why? This is a reasonable measure, that any short seller should be compliant with before trading. However, we would suggest changing the final sentence to: "...other arrangements which ensure that it will be able to provide the shares at time of settlement." This means that intra-day trading, with the intention of buying back the shares the same day, will be possible. 4

5 14. Do you consider that the risks of uncovered short selling are such that they should be subject to an upfront ban/permanent restrictions? If so, why? No. Restrictions on uncovered short selling would create new risks, such as removing the positive incentive for companies and governments to behave in a way that inspires market confidence. 15. Do you agree with the proposal requiring buy in procedures for settlement failures due to short sales? If so, what is an appropriate base period that could be specified before buy in procedures are triggered (e.g. T + 4)? The buy-in measures are sensible; however, it seems possible that a short seller failing to deliver may be having trouble with stock availability. It is unclear whether the exchange would always have more luck. 16. Do you consider that there should be permanent limitations or a ban on entering into naked credit default swaps relating to EU sovereign issuers? If so, please explain why, including if possible any evidence relating to the use of naked CDS. No. To single out naked CDS as a villain is simply wrong. As shown with Greece, the CDS market is simply too small to be relevant, and the price falls actually lagged that physical market. But even that were not the case, then a ban would simply lead to other approaches to speculation on or protection form errant governments, such as currency, or corporate debt. And in many cases, what appear at first sight to be naked sales are likely to have been hedging similar but not identical exposures. 17. Do you consider that in addition to the measures described above there should be marking of orders for shares that are short sales? No. This is too complicated a question. Whether or not a trade is genuinely short may depend on aggregation of exposure across different instruments. The resulting data would be subjective and unreliable. 18. What is the likely costs and impact of the different options on the functioning of financial markets? In general it is simply good business practice to know how you are going to settle before engaging in a trade, so there should not be a disproportionate cost attached to it. D: EXEMPTIONS 19. Do you agree with the proposed exemption for market making activities? Which requirements should it apply to? No. There is too much risk of abuse by market makers. See question Do we need any exemption where the principal market for a share is outside the European Union? Are any other special rules needed with regard to operators or markets outside the European Union? This question should be partly driven by diplomacy with specific countries such as the US. In general, disclosure to EU regulators should be applied anyway, but public disclosure or restrictions may be chiefly the concern of the other country. 5

6 21. What would be the effects on the functioning of markets of applying or not applying the above exemptions? The application of the exemption to market makers could lead to market abuse or the appearance of market abuse, as discussed in Question 9. Without the exemption, notification to the regulator would not cause any disturbance, providing the activities are low risk. E: EMERGENCY POWERS OF COMPETENT AUTHORITIES 22. Should the conditions for use of emergency powers be further defined? It is unclear whether the question relates to the existing emergency powers of sovereign countries' home regulators, or whether it should relate to the proposed emergency powers of the ESMA under Article 10 of the proposal for the establishment of the European regulator. However, in general, emergency powers are needed to deal with unexpected events; and thus it is counter-productive to be too specific in these matters. 23. Are the emergency powers given to Competent Authorities and the procedures for their use appropriate? Regulators should be free to intervene in their own markets as they deem necessary. They are generally closest to, and most interested in, the welfare of the home market. They should nevertheless be free to seek advice and consensus from other countries. They will presumably be keen to ensure that their actions are not deemed excessive, as that could deter genuine investors from participating in their markets. 24. Should the restrictions be limited in time as suggested above? Default limitations in time are better than none, but as seen in the case recently, if a country wants to extend restrictions indefinitely, they will do so, even at the risk of losing a reputation for fostering fair and efficient markets. 25. Are there any further measures that could ensure greater coordination between competent authorities in emergency situations? Coordination is mainly a diplomatic issue. It is preferable for members of the EU to collaborate voluntarily. Germany's unexpected ban on naked short sales did not foster collaboration between countries ; but Britain's collaboration with France and Germany over the bank tax announced recently was much more in keeping with the spirit of collaboration. 26. Should competent authorities be given further powers to impose very short term restrictions on short selling of a specific share if there is a significant price fall in that share (e.g. 10%)? We have seen the effect of "circuit breakers" in countries such as India, which suspend all trading when there is a significant price change. With rare exceptions, they do seem to make the market more efficient, as they restrict hysterical over-reactions and excessive momentum buying or selling. We believe that it is wrong to single out short sellers in this type of situation; however, it might have little effect since there is some evidence to suggest that the short sellers often get into their trades before the price has moved significantly, and that panic selling is mainly from physical sellers, while the short sellers are buying back their positions and providing liquidity in the market. 6

7 27. Glossary: The definition of "competent authority" looks a little thin and uninformative. "short sale" is a much wider topic, and borrowing could easily be replaced by a repo agreement to get around the definition. "net short position" will be highly variable where there are different types of instrument offsetting each other. For example, an option giving the right to sell 1,000 shares does not offset 1,000 physical shares exactly. Much depends on the difference between the share price and the strike price at which the shares could be sold. The "delta" of an option describes the amount of the underlying shares which offsets the risk exactly at one moment. But if the share price changes, the delta will change too. The speed of change of the delta can vary enormously, so a disclosure that is true and valid on one day could be extremely misleading about the underlying risk, should a small change in the price of the underlying happen. Christopher Miller CEO, Investment Quotient christopher.miller@investmentquotient.com 7