A curious story emerged earlier this year when a man was charged with planting a bomb under the Borussia Dortmund football club team bus in April. It was initially suspected as the work of terrorists but the truth was actually much stranger—it was a short seller.
The man, a 28-year old known only as Sergei W, set the bomb to profit from 15,000 put options he had purchased in anticipation of the club’s share price slumping post-attack. Ironically, the damage from the bomb was shrugged off in the financial markets. The club’s shares fell further after Dortmund had been eliminated from the Champion’s League the week after the attack then on that particular day.
This odd tale might confirm the nefarious reputation that many short sellers have in the public eye. The European short selling regulation (SSR)—established in 2012—came out of the woes of the financial crisis and was designed in reaction to the public disapproval of short sellers who were blamed for exacerbating the crisis and profiting from the losses of others.
The rules, which were drawn up by the European Securities and Markets Authority (ESMA), focus on market discipline and disclosure. Firstly, naked short selling is prohibited. Short sellers need to have borrowed, or have an expectation of borrowing, securities which can be delivered on settlement.
More significant is short selling disclosure. Investors must privately notify the trading venue they are using if they are shorting more than 0.2% of the total issued equity of a company and publicly disclose at 0.5%. On top of this, additional notifications and disclosures are required for every 0.1% additional short position of issued share capital above these two thresholds. According to participants, the disclosure rule is onerous and time consuming and, in the case of the public reporting requirement, can lead to front running or herding activity. Indeed, according to Oliver Robinson, associate director, markets regulation, at the Alternative Investment Management Association (AIMA), the short selling rules are regularly cited in the top three most contentious bits of legislation by alternative fund managers.
“In terms of members having issues with regulations this is always in the top two or three,” says Robinson. “The public disclosure can create a herding effect or people deliberately trying to squeeze those who have got a short position. It was a politically driven rule post-2008 in response to perceived speculation and profiting off downward moves.”
Exploiting loopholes
The added administrative burden on participants to comply with the disclosure rules is not easy, say participants. Investors have to place a close watch not only their own positions, but also on the issued share capital for a company. This is made more complex by the lack of an obligation for issuers to publish this figure and absence of a centralised database in the market which tracks this information.
“It can several hours per day to complete these notifications,” says Robinson. “The range of individual notification platforms and mechanisms across countries means that each report has to be submitted manually. And because the issued share capital figure provided by commercial providers is often incorrect, it must be double checked.”
There is no doubt that the disclosure rules have changed the way that short sellers do business.
“If you have to disclose a short position you might find it harder to get boardroom access,” says Cyrus Pocha, a senior associate at Freshfields. “Companies are not enamoured when they find their stock is being shorted.”
At the same time, there remain loopholes around the SSR which hedge funds have been seeking to exploit. Earlier this year Tiger Global hedge fund, which has $20bn in assets under management, was brought to the public’s attention for shorting shares in Tesco using an offshore shell company registered in the Cayman Islands with the aim of maintaining anonymity. It is not the first time it has done so—the hedge fund was also involved in the same activity in 2014. “It is a roundabout way to do short selling and mask who is doing it,” says Pocha. “But that’s an outlier rather than the common position.”
Industry pressure
Bearing all this in mind the clamour to make the rules more efficient has been growing. Last October, AIMA sent a letter to ESMA asking for a centralised data repository and reporting platform to enable all reporting to be done on the same system irrespective of location as well as providing information on which shares are in scope of the SSR and the issued share capital figure for each issuer. It also asked for an extra 24 hours to enable market participants to report their positions.
Robinson says that its members are also in favour of the public disclosure requirements to be removed, or at least replaced with an anonymous system which would have aggregated public short position data rather than showing individually named investors.
And finally it seems that ESMA might be listening. In July, the regulatory authority launched a consultation paper with plans to update its short selling regulation—partly in response to the market calls for change.
“The analysis of the responses to the consultation paper...in 2013 showed a desire and some suggestions to review the rules on short selling,” says a spokesperson for ESMA. “Additionally, in their response to the European Commission (EC) call for evidence on the European regulatory framework in 2016 some industry representatives questioned the appropriateness of maintaining the public disclosure regime of net short position established by the SSR.”
The consultation focuses on three areas of the existing rules. Firstly ESMA is reviewing exemptions for market makers from the SSR. The idea is to harmonise the definition of market maker under MiFID II with the SSR. It will also look at the efficacy of emergency measures to ban short selling in times of market dislocation. However, the most significant part of the review focuses on the disclosure aspect. ESMA has asked for advice on the appropriateness of the “method of notification and disclosure” of short positions and whether this could be made less burdensome and costly for reporting entities and whether public disclosure of net short positions in shares are effective. It also posed the question of whether the thresholds for disclosure—both public and private—should be changed.
News to follow
The noises seem encouraging. Yet whether ESMA will deliver what the industry wants is another matter. Certainly Robinson does not believe that there will be any change in the disclosure thresholds.
“We don’t support the 0.5% public disclosure threshold, though recognise that politically it will probably be hard to change,” says Robinson. “Our primary target is to make the regime more efficient, thus assisting the majority of firms that use short selling for dynamic risk management and hedging purposes as well as those that take fundamental directional positions.”
As for the loophole—ESMA says it has no intention of looking at short selling using special purpose offshore structures.
The regulator has had its hand strengthened by the continued critical voices around the world. Despite the already stringent rules, participants around the globe have been asking for further tightening. In June, Tom Farley, head of the New York Stock Exchange, said that short sellers should be forced to reveal more of their activities and called the practise of short selling “icky and un-American.”
The consultation closed in September and the regulatory body will deliver its final advice to the EC by the end of the year. But, despite the market’s noises it seems there will continue to be strictures post-review which are unlikely to lead to the kind of progress that short sellers are hoping for.