I learned to value the contribution made by short-sellers toward keeping our markets honest.

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1 MEMO To: European Commission, Directorate General Internal Market and Services From: Flow Traders B.V. Re: Resonse to Public Consultation on Short Selling Date: 9 July 2010 Dear Sirs, Flow Traders B.V. ( Flow ) appreciates the opportunity to respond to your public consultation on short selling. Flow is licensed with the Netherlands Authority for the Financial Markets ( AFM ) to act as a market maker on the cash markets. Before we respond to your questions in the consultation document we would like to emphasize the important role of conventional short selling and its central economic function by quoting Mr Richard C. Sauer, the author of Selling America Short: The SEC and Market Contrarians in the Age of Absurdity : 1 The main virtues of short selling are these. It adds liquidity to the market by increasing transaction volume. It provides a hedging mechanism for many other types of investment activities, including some conducive to capital formation. Most important, it injects into the market a healty skepticism to counter the blind enthusiasm, ignorance and occasional fraud that otherwise may run unchecked. The great majority of investors stay exclusively on the long side. They have limited incentive to seek out (and less to publicize) negative information about public companies. Professional shorts, however, have both the motivation and the skills to look beyond the happy talk of company management and sell-side analysts. These bear investors have provided early warnings of such corporate blowups as Enron and deflated many a pump-and-dump scheme. More generally, they help true up the value of publicly traded securities by making certain their negatives do not go unseen. (...) I learned to value the contribution made by short-sellers toward keeping our markets honest. 1 Richard Sauer was an administrator with the Division of Enforcement of The Securities and Exchange Commission, a partner in an international law firm and a analyst with a Northern California hedge fund. He holds a doctorate in law from Harvard Law School. Complete article ( When short selling is good ) can be found at:

2 2 We believe the policy goals behind the regulatory constraints on short sales are: 1) reducing settlement risks (i.e. preventing failed deliveries), and 2) mitigating the downward momentum on prices during market panics. We are of the opinion the first of these goals can be addressed with a system that is already in place and could be bolstered by greater harmonization within Europe that is, clear and strict buy-in regimes. Buy-in procedures ensure against settlement failure without changing upfront otherwise healthy market behavior or dampening the benfits short selling can provide in the market. To address the second of these goals, regulators first need to examine more closely the cause. There has been a media and political tendency to demonize short selling in this context. However, as we have recently seen with the Flash Crash, which occurred in a regulatory context in which short sales have been highly regulated since 2005, constraints on short selling do not prevent market panics. Downward price momentum arises from a multitude of factors, not insignificantly due to differing regulatory regimes of exchanges and the use of stop loss orders that convert into market orders. Disparate exchange rules can create a regulatory arbitrage situation that produces vacuums of liquidity during an emergency moment in the market. It is the dearth of liquidity, rather than the presence of short sellers, that contributes to downward price pressure. Harmonization among exchange rules in Europe would certainly mitigate this effect. Moreover, investors wishing to liquidate long positions often use stop loss orders that convert to market orders upon prices decreasing, in order to protect them against even greater losses. It is the conversion to market orders that can trigger domino effect price decreases. This could be mitigated by the use of collared orders or circuit breakers, to reduce the risk that unpriced orders would get executed intra-day at prices significantly below theoretical value. Therefore we believe it is essential that regulators do not underestimate the benefits short selling provides in the market, including contributing to efficient price discovery, mitigating market bubbles, increasing market liquidity, promoting capital information, facilitating hedging and other risk management activities, and limiting upward market manipulations. A. SCOPE (1) Which financial instruments give rise to risk of short selling and what is the evidence of those risks? While we do not believe that short selling per se gives rise to risks in the market, if we are to assume some regulatory constraint is desirable, we would view only the shares of leading EU financial companies as relevant for any discussion on the merits of short sale regulation. We feel an important point to address here is that the objective of reducing risks to market integrity has already been addressed in the Market Abuse Directive (MAD). We hope regulators will remain vigilant in discerning between the concepts of short selling and market

3 3 abuse these are not one in the same. Where a short selling activity does reach the level of market abuse, this broad regime provides sufficient powers to act and to impose necessary measures. Short selling regulations to reduce systemic risks and risks to financial stability should be in separate stand-alone legislation, the Short Selling Directive (SSD). (2) What is your preferred option regarding the scope of instruments to which measures should be applied? We would prefer that short sale regulation is as specific and concrete as possible, applicable only to the shares of leading EU financial companies. (3) In what circumstances should measures apply to transactions carried on outside the European Union? In order to create a level playing field, any regulation of short sales in financial instruments listed and traded in the EU should be applied across the board to all transactions, irrespective of where they initiate. B. TRANSPARENCY (4) What is your preferred option in relation to the scope of financial instruments to which the transparency requirements should apply? We believe transparency requirements will incur significant costs and have an uncertain benefit attached. Transparency and notification will not decrease settlement failures. The disadvantage of increasing the costs of transacting for market participants performing the very valuable task of liquidity provision is that liquidity may suffer. If transparency requirements are implemented, we believe their scope should be limited to the shares of leading EU financial companies. (5) Under Option A is it proportionate to apply transparency requirements to all types of instruments that can be subject to short selling? No, it is disproportionate. (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? (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 a public disclosure of significant short positions?

4 4 (8) Do you agree with the methods of notification and disclosure suggested? Should any notification requirements be implemented, we believe it would be sufficient to provide notice to the relevant competent authorities, which would thereafter have responsibility for any further public disclosure if deemed necessary. (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? Yes, there should be an exemption for market makers (as have been in place in most of the European Member States). As stated by the EC, market making is important to the efficiency of markets and short sale constraints could severely inhibit their ability to provide liquidity to European markets. (10) What is the likely costs and impact of the different options on the functioning of financial markets? Reports investigating the impact of the July 2008 Emergency Order mandating pre-borrow requirements in the US show significantly increased transaction costs, with dramatic spikes in average lending fees and sharply increased bid-ask spreads for the affected stocks. We expect the same impact to occur in Europe upon implementation of similar rules. C. UNCOVERED SHORT SALES (11) What are the risks of uncovered short selling and what is the evidence of those risks? (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? No. There is evidence that the adverse liquidity effect of bans or other regulatory constraints on short selling is stronger for stocks that do not have outlets for related or derivative products, such as listed options. (13) Do you agree with the proposed rules 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?

5 5 We believe pre-borrow and hard locate requirements do not guarantee delivery, but do significantly increase transaction costs. As previously stated, we believe a firm and clear buy-in regime is a better option for addressing the concerns of naked short selling. However, in the context of a discussion on borrowing requirements, we agree that the concept of pre-borrowing, which entails reasonable grounds to believe that a security can be borrowed, is preferable to hard locate requirements. (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, we absolutely disagree with the idea of an upfront ban. Permanent restrictions also seem disproportionate to the impact of uncovered short sales. If anything, we believe in regulating uncovered short selling over banning it. The starting principle should always be that conventional short selling uncovered short selling included - helps to keep financial markets honest. Any restrictions should be subject to clear processes and to coordination by ESMA. (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)? Yes. T+4 is an appropriate base period. (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. (17) Do your consider that in addition to the measures described above there should be marking of orders for shares that are short sales? No, we think that the measures described above, used in the situations described above, will be sufficient. (18) What is likely costs and impact of the different options on the functioning of financial markets?

6 6 D. EXEMPTIONS (19) Do you agree with the proposed exemption for market making activities? Which requirements should it apply to? Yes. Market makers acting generally in their capacity as market maker should be exempted from all requirements, including any notification requirements. See also under (9). (20) 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? Yes. The Commission s aim is to work towards a more harmonized regime to increase the resilience and stability of financial markets in the European Union. (21) What would be the effects on the functioning of markets of applying or not applying the above exemptions The exemption for market making activities follows from the recognized role market makers around the EU play to provide continous liquidity to European markets. This crucial role was flawlessly played during the lowest point of the unprecedented financial crisis in Q To maintain this role is essential. E. EMERGENCY POWERS OF COMPETENT AUTHORITIES (22) Should the conditions for use of emergency powers be further defined? We have seen during the financial crisis since 2007 that regulators, often under pressure from politicians and the media, have intervened in often hurried, irresponsible, and most importantly, unsynchronized ways that had a deleterious effect on the markets, including slowing price discovery, increasing bid-ask spreads, and reducing liquidity. We believe emergency powers granted to regulators should therefore be granted with caution. To achieve fully harmonized rules and tools across the EU these conditions need to be further defined. There should be no room for the concept of comply or explain, as mentioned on page 13 of the consultation document in taking action contrary to the ESMA advice. (23) Are the emergency powers given to the Competent Authorities and the procedures for their use appropriate?

7 7 (24) Should the restrictions be limited in time as suggested above? Yes. (25) Are there any further measures that could ensure greater coordination between competent authorities in emergency situations? A central role for ESMA as a binding force with no room for action taken contrary to its advice is crucial. (26) Should competent authorities be given further powers to impose very short term restrictions on short selling of a specific share it there is a significant price fall in that share? (e.g. 10%)? Rules that will require EU trading venues to pause trading in certain individual shares if the price moves 10 percent or more in a five-minute period ( Circuit Breakers ) could have a positive effect on the market and work against downward price pressure in moments of volatility. F. POWERS OF COMPETENT AUTHORITIES (27) Should the power to prohibit or impose conditions on short-selling be limited to emergency situations (as set out in the previous section)? Yes, however, see comments above under (22) (28) Are there any special provisions that are necessary to facilitate enforcement on the future legislation in this area? As the need for close consultation and co-ordination between Competent Authorities is essential where an emergency extends beyond one Member State or has other cross border implications, the ESMA should perform a key coordination and facilitation role. Therefore (i) conditions under which emergency action may be taken; (ii) the procedures for taking action and (iii) the scope of powers themselves should be fully harmonized. Unilateral conduct is incomprehensible and undesirable. (29) What co-operation powers should be foreseen for ESMA on an ongoing-basis? All the co-operation powers necessary to let ESMA perform its key coordination and facilitation role.

8 8 G. GLOSSARY OF DEFINITIONS Question: (30) Do the definitions serve their intended purpose? We are concerned the conceptual framework is incomplete. Conceptions like exceptional circumstances, necessary powers, emergency and significant should be made clear to achieve fully harmonized rules and tools and equivalent and predictable enforcement around the EU.