The European Commission (EC) has tabled proposals aimed at making derivatives trading and short selling more transparent and efficient.
Under the draft legislation, many OTC derivatives trades in the EU will be cleared through central counterparties (CCPs) and reported to trade repositories. The new reporting requirements will enable market participants to view aggregated European positions for each derivative class for the first time.
Short sellers will have to disclose their net short positions to regulators once they reach 0.2% of issued share capital and to the market when they reach 0.5% of issued share capital.
National regulators will also be given the authority to restrict or ban short selling in coordination with the new pan-European regulatory body for securities trading, the European Securities and Markets Authority (ESMA), which is expected to come into being in Q1 2011. ESMA will have the power to enforce the same rules as a national regulator, even superseding the regulator's previous actions in exceptional circumstances.
The proposals follow a series of consultations with market participants by the EC and ESMA's forerunner, the Committee of European Securities Regulators (CESR) on, short selling and OTC transactions.
Both OTC derivatives trading and short selling were seen as causes of market instability in the financial crisis. The Group of 20 countries (G20) agreed in September 2010 that “all standard OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest”. On 26 June 2010, the G20 agreed to accelerate measures “to improve transparency and regulatory oversight of hedge funds, credit rating agencies and OTC derivatives in an internationally consistent and non-discriminatory way”.
The proposals – unveiled by single market commissioner Michel Barnier – will now pass to the European Parliament and the EU member states for consideration. Once adopted, the short selling rule would apply from 1 July 2012 and the proposal on OTC derivatives from the end of 2012.
Barnier said Europe had to work with other territories such as the US and Hong Kong warning that “No financial market can afford to remain a Wild West territory.” He also emphasised that recording of and reporting activity was required rather than simply asking for firms to be open about their business, “Transparency alone will not suffice. We wish to improve the global management of these financial markets through standardisation. This will enable us to monitor risks better. Almost total registration of OTC trades in trade repositories will be necessary.”
The reporting of European OTC derivative trades to trade repositories has been proposed by the EC to enable the unwinding of firms' derivative positions, something that proved very complex following the collapse of Lehman Brothers on 15 September 2008. By requiring trades to be cleared through a CCP, which takes one side of a contract in every deal, replacing the buyer or seller, the EC aims to limit the risk or market participants accruing oversized exposures.
Under the proposals, certain OTC derivatives transactions and participants will be exempt from the new reporting and clearing requirements.
Contracts between two non-financial firms, which the EC notes represent a fraction of total contracts, where neither firm exceeds an ‘information threshold’ will not need to be reported to a trade repository, while contracts entered into by non-financial firms below a ‘clearing threshold’ will not have to be cleared through a CCP. ESMA is to determine these thresholds which are not set out in the proposals.
The draft legislation gives ESMA the power to decide which class of OTC derivative should become subject to clearing obligations. ESMA may, on its own initiative and in consultation with the European Systemic Risk Board, identify contracts that should be cleared via a CCP. Alternatively, the new securities regulator can approve or reject the decision of a competent authority to authorise a CCP to clear a class of derivatives.
As certain derivatives are customised to meet particular counterparty or end-user needs, the EC has acknowledged that some bespoke OTC derivatives products will not have the level of standardisation needed for centralised clearing, something that had concerned many respondents to the consultations.
Short selling has already been the subject of temporary bans in many EU member states due to concerns that the practice accelerates the decline in value of stocks and government bonds in periods of market volatility.
To ensure that regulators or competent authorities in EU member states are able to temporarily ban or restrict short selling where it is perceived to threaten the market, the proposal suggests that the authority must notify ESMA of measures it wishes to take at least 24 hours in advance. ESMA will issue an opinion (within 24 hours) on whether the proposed measure is appropriate to address the threat, and whether measures by other competent authorities are necessary. A competent authority that takes action contrary to ESMA’s opinion will have to publish its reasons. ESMA will also be able to initiate restrictions on short selling if it perceives a threat to the market's functioning.
Naked short selling has effectively been banned by the ”locate rule' under which “an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party who has located and reserved them so that that they are delivered by the settlement date”.
Activities involving market making, primary market activity or involve shares that are primarily traded outside of the EU have been exempted from the rules.
In circumstances where activity occurs outside of the EU, regulators are required to reach cooperation agreements with regulators in third countries where EU shares or sovereign bonds and associated derivatives are traded.