For those hoping to learn more about this important function in our markets, this new presentation offers helpful information on what short selling is and how it works, different types of short selling, and provides an overview of the regulatory actions taken both in the U.S. and in Europe. Other topics covered in the presentation include: The benefits of short selling and how it is used as a hedge How short selling is regulated in the United States A brief overview of current EU short selling regulations The economic effects of short selling bans in the U.S. and Europe An overview of MFA’s global advocacy on short selling issues

1. SHORT SELLING
A BRIEF OVERVIEW AND REGULATORY UPDATE
Managed Funds Association
February 2014

2. Short Selling
Executive Summary:
Contents
Executive Summary
Short selling is a strategy used by investors to balance
portfolio allocations and manage risk. It also performs
a number of important roles in the marketplace – aiding
with price discovery and providing much-needed
liquidity.
This presentation offers a brief overview of short
selling, the benefits it provides for investors and the
marketplace, and how it is regulated in the United
States and European Union.
2
What is Short Selling?
3
How Does Short Selling Work?
5
The Benefits of Short Selling
6
How is Short Selling Regulated in
the U.S.?
7
Regulation SHO
8
European Short Selling
Regulations
10
Short Selling Regulation in the
EU
12
Short Selling Bans
13
Effects of Short Selling Bans
14
MFA Advocacy
16
References
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3. What is Short Selling?
Short selling is a trading strategy fund managers and other investors employ when they
believe that shares of a particular stock are overpriced.
It generally means borrowing a security (or commodity futures contract) from a broker
and selling it, with the understanding that it must later be bought back (hopefully at a
lower price) and returned to the broker.
The short seller closes out the short position by purchasing equivalent securities on the
open market, or by using an equivalent security it already owned, and returning the
borrowed security to the lender.
Short selling can be used to profit from an anticipated downward price movement, to
provide liquidity, or to hedge the risk of a long position in the same security or in a related
security or other type of long exposure.
Source: http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm
.
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4. What is Short Selling?
Types of Short Selling:
In covered short selling, the investor has made arrangements to either borrow the securities or to
ensure that they can be borrowed to perform the transaction.
A naked short sale is one in which the investor does not own the securities at the time of the sale and
has not made arrangements to borrow them in time to make delivery to the buyer within the standard
three-day settlement period.
If the seller does not deliver shares within the required time frame, that is known as a “failure to deliver.”
A failure to deliver generally does not occur in a covered short sale because an investor has ensured
that shares can be borrowed and delivered.
MFA consistently supports regulatory proposals
in the U.S. and Europe that are designed to
prevent naked short selling (except in limited
circumstances, such as market making).
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5. How Does Short Selling Work?
100 SHARES XYZ = $2500 VALUE
Mr. Doe is worried about XYZ Co’s upcoming earnings
report, however, and decides to offset this long position by
selling short ABC Inc. stock - which is in the same market
sector as XYZ Co. and would likely also lose value should
XYZ report poor earnings.
BORROW 100
shares ABC
@$25/share
John Doe holds 100 shares of XYZ Co. - valued
at $25 per share – as a long investment position.
Mr. Doe makes arrangements to borrow 100 shares of
ABC Inc. stock at $25 per share and immediately sells it in
the marketplace netting $2,500. Mr. Doe must return the
borrowed shares at a specified date.
SELL 100 borrowed
shares ABC
@$25
PROFIT FROM SALE of
ABC shares = $2500
As anticipated, the earnings report is negative and XYZ Co. and ABC Inc. stocks both decrease in value to $20 per share.
Mr. Doe buys back the quantity of ABC Inc. stock needed to cover his short position (100 shares at $20 per share for a
total cost of $2,000).
BUY 100
shares
ABC@$20
RETURN
100 shares
ABC to lender
COST TO PURCHASE
100 shares ABC @$20
= $2000
Mr. Doe has earned a profit of $500 on the short sale and offset the decrease in value of the long position held in XYZ Co.
LOSS on100 shares XYZ =
PROFIT from short sale of ABC shares =
-$500
$500
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6. The Benefits of Short Selling
How Does Short Selling Affect Markets?
The ability to quickly blend positive and negative information into share prices is essential
for markets to work efficiently.
Short selling provides the following benefits in the marketplace:*
•
•
•
•
•
•
•
*
Increased liquidity
Increased capital formation
Improved price discovery, which bolsters investor confidence
Decreased transaction costs (e.g. smaller bid-ask spreads)
Decreased occurrences of price bubbles and / or crashes
Efficient risk allocation
Hedging against long term investment positions
SEC Securities Lending and Short-Selling Roundtable : 9/29/09-9/30/09
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7. How is Short Selling Regulated
in the U.S.?
Short Selling Regulations in the U.S.:
The SEC is the government agency tasked with regulating securities markets in the U.S.
Throughout the years, the SEC has developed and implemented various regulations related to short selling,
including Regulation SHO, which it finalized on August 6, 2004 and has supplemented in recent years.
Regulation SHO was adopted under the Securities Exchange Act of 1934 to meet the following goals,
according to the SEC:
•
Establishing uniform “locate” and “close-out” requirements to address
problems associated with failures to deliver, including “potentially
abusive ‘naked’ short selling.”
•
Creating “uniform order marking requirements” for all equity securities
sales, requiring participants to label orders placed with broker-dealers
as “long,” “short,” or “short exempt.”
Source: http://www.sec.gov/spotlight/keyregshoissues.htm
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8. Regulation SHO
Regulation SHO applies to short sales of equity securities and includes,
among others, the following key components:
Locate
Requirement
Regulation SHO requires a broker-dealer to have “reasonable grounds” to
believe the specified security can be borrowed so that it can be delivered on
the due date before executing a short sale. Broker-dealers are required to
document the ‘location’ before making the transaction.
“Close-out”
Requirement
Broker-dealers must close-out any outstanding failure-to-deliver positions
(“open-fails”) by the settlement day, following the settlement date.
MFA generally believes Regulation SHO is an effective approach to the
regulation of short selling in the U.S.
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9. Regulation SHO
Regulation SHO has been amended since implementation in 2005 to include new rules governing
certain aspects of short selling:
Rule 201
Known as the “alternative uptick rule,” the SEC approved Rule 201 in February
2010 as an amendment to Regulation SHO. The rule includes a “short salerelated circuit breaker,” which is triggered when a security’s price declines by 10
percent or more in a day. Once triggered, short selling of that security is only
permitted if the price is above the current national best bid.
Rule 201 applies to all equity securities listed on a national securities exchange,
regardless of whether they are traded in an exchange or over-the-counter markets.
Rule 204
Short Sale Data
In July 2009, the SEC amended Regulation SHO to include Rule 204 to reduce
fails-to-deliver and curb abusive “naked” short selling. The SEC developed this
rule in response to persistent “fails to deliver” in the marketplace, penalizing firms
if they do not close out fails in a timely fashion.
Several self-regulatory organizations (SROs) provide daily aggregate short selling
volume in formation on their websites and on a one-month delayed basis,
information regarding individual short sale transactions in all exchange-listed
securities. All of this information can be found on the SEC’s website:
http://www.sec.gov/answers/shortsalevolume.htm.
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10. European Short Selling Regulations
European Union and Member State Regulations:
European nations traditionally regulated short selling individually, rather than collectively through the
European Union (EU). For example, during the financial crisis in 2008, several EU member states
independently implemented independent emergency measures restricting or banning short selling.
Subsequently, the European Commission released a proposed regulation in September 2010 related to
short selling and certain aspects of credit default swaps (CDS). The proposal introduced common
requirements for EU Member States and powers to harmonize regulation across Member States.
After months of negotiations among the European Parliament, the Council of the European Union and
the European Commission, a final text was agreed to in October 2011, and it was officially signed on
March 14, 2012 by MEP Martin Schulz, the President of the European Parliament, and Nicolai
Wamman, the EU Affairs Minister of Denmark (which held the rotating presidency of the Council of the
European Union).
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11. European Short Selling Regulations
European Union and Member State Regulations:
•
Short selling Regulation was signed on March 14, 2012.
•
The European Securities and Markets Authority (ESMA) developed its draft advice and
presented it to the European Commission on April 20, 2012.
•
The European Commission adopted its final delegated acts and regulatory technical standards
on July 5, 2012.
•
The Regulation took effect on November 1, 2012.
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12. European Short Selling Regulations
The new regulation covers a number of items,* including:
Reporting &
Disclosure
The regulation requires reporting of net short positions to regulators over a
certain threshold, and public disclosure of net short positions over a higher
threshold.
Location
The regulation requires parties entering into a short sale to have borrowed
the instruments, entered into an agreement to borrow them or made
arrangements with a third party under which that third party has confirmed
that the share has been located.
Transparency &
Restrictions
The regulation also provides competent authorities with power to require
greater transparency or impose certain restrictions on short selling in
emergency situations.
*
The regulation also imposes restrictions on EU sovereign CDS, which are not covered in these materials. More
information on EU short selling regulation can be found here.
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13. Short Selling Bans
U.S. and UK Short Selling Bans and the Financial Crisis:
During the height of the financial crisis, several international regulators put in place
emergency measures to restrict the short selling of various financial companies and other
issuers.
In September 2008, the U.S. SEC issued an Order Halting Short Selling of certain
financial securities in an attempt to “restore equilibrium to the markets.” The SEC acted in
conjunction with the UK’s Financial Services Authority (FSA), which instituted a similar
ban.
**The
Managed Funds Association, Comment Letter to Jean-Pierre Jouyet, pp. 2, August 13, 2011.
Managed Funds Association, Comment Letter to Steve Maijoor, pp. 2, August 14, 2011.
*”Why Banning Short-Selling Doesn’t Do Any Good.” August 12, 2011. CNBC.com
**The
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14. Effects of Short Selling Bans
SEC Short Selling Ban:
Following the SEC’s Order Halting Short Selling, numerous studies were conducted that analyzed the
effects of the ban on markets. The studies generally found that the ban:
•
•
Did not stop the steep price declines (see chart below, from study by Oliver Wyman,* on stock
declines during the U.S. and UK short sale bans – noted in gray);
Increased volatility;
•
Made capital raising more
difficult for certain issuers;
•
Reduced market efficiency;
•
Decreased trading volume
and market liquidity; and
•
Increased bid-ask
spreads―from a normal
average of 17 basis points in
2008, to 60 basis points by
October 8, 2008.
*”"The
effects of short-selling public disclosure regimes on equity markets,“ Oliver Wyman, pp. 7.
Funds Association, Comment Letter to Jochen Sanio, August 13, 2011, pp. 2.
**”Why Banning Short-Selling Doesn’t Do Any Good.” August 12, 2011. CNBC.com
**Managed
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15. Effects of Short Selling Bans
Short Selling and the European Debt Crisis:
A number of EU Member States took regulatory action in 2011 attempting to reduce market
volatility resulting from the sovereign debt crisis. France, Italy, Spain and Belgium instituted
temporary bans on short selling of financial companies in August 2011. The bans were
lifted in February 2012. Further bans on short selling were instituted in Italy, Spain, and
Greece in July 2012.
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16. MFA Advocacy
MFA believes short selling plays an important, constructive role in the
financial marketplace and that evidence shows short selling benefits
financial markets and investors.
As new regulations take effect, MFA will be monitoring their affect on short
selling and markets generally. MFA will continue our conversation with
regulators to see if the regulations are achieving their stated goals.
MFA opposes any market manipulation, long or short. MFA’s members
depend on free, open, and fair markets, free from any manipulation. MFA
supports regulatory initiatives that identify and prevent fraud.
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17. References
U.S. Regulatory Agencies:
Securities and Exchange Commission (SEC)
www.sec.gov
European Resources:
1. European Commission
http://ec.europa.eu/internal_market/securities/short_selling_en.htm
2. Council of the European Union
http://ue.eu.int/
3. European Parliament
http://www.europarl.europa.eu/news/en/headlines/
4. European Securities and Market Authority (ESMA)
www.esma.europa.eu/
5. Financial Services Authority (UK)
http://www.fsa.gov.uk/
MANAGED FUNDS
ASSOCIATION
Additional Resources:
International Organization of Securities Commissions
http://www.iosco.org/
Managed Funds Association
www.managedfunds.org
@MFAUpdates
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