COMMISSION STAFF WORKING DOCUMENT SUMMARY OF THE IMPACT ASSESSMENT   Accompanying document to the   Proposal for a   REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL  on Short Selling and certain aspects of Credit Default Swaps   {COM(2010) 482 final} {SEC(2010) 1055}
Date: 2010-09-15
Institutions: European Commission
Subjects: credit policy, financial instrument, financial legislation, financial market, financial policy, sale, swap arrangement

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EUROPEAN COMMISSION 

Brussels, 15.9.2010 
SEC(2010) 1056 

COMMISSION STAFF WORKING DOCUMENT 

SUMMARY OF THE IMPACT ASSESSMENT 

Accompanying document to the 

Proposal for a  

REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL 

on Short Selling and certain aspects of Credit Default Swaps 

{COM(2010) 482 final} 
{SEC(2010) 1055} 

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1. 

PROBLEM DEFINITION  

At  the  height  of  the  financial  crisis  in  autumn  2008,  competent  authorities  in  the 
United  States  and  several  EU  Member  States  adopted  exceptional  measures  to 
restrict or ban short selling in some or all shares. They acted due to concerns that at a 
time  of  considerable  financial  instability,  short  selling  was  aggravating  the 
downward  spiral  in  the  prices  of  shares,  notably  in  financial  institutions,  in  a  way 
which  could  ultimately  threaten  their  viability  and  create  systemic  risks.  The 
measures adopted by Member States were divergent as the European Union lacks a 
specific legislative framework for dealing with short selling issues.  

In  March  2010,  concerns  were  expressed  by  some  governments  also  about  the 
possible role played by derivative transactions, notably Credit Default Swaps (CDS), 
in relation to the prices for Greek sovereign bonds. A number of Member States have 
adopted  temporary  or  permanent  restrictions  at  national  level  on  short  selling  and 
CDS.  

Short selling is the sale of a security that the seller does not own, with the intention 
of buying back an identical security at a later point in time to be able to deliver the 
security. It can be divided into two types: "covered" short selling where the seller has 
made arrangements to borrow the securities before the sale and "naked" short selling 
where  the  seller  has  not  borrowed  the  securities  when  the  short  sale  occurs.  In 
addition to short selling on cash markets, a net short position can also be achieved by 
the  use  of  derivatives,  whether  they  are  traded  on  exchanges  or  over-the-counter 
(OTC). 

A  Credit  Default  Swap  (CDS)  is  a  derivative  which  acts  as  a  form  of  insurance 
against  the  risk  of  credit  default  of  a  corporate  or  a  government.  In  return  for  an 
annual  premium,  the  buyer  of  a  CDS  is  protected  against  the  risk  of  default  of  a 
given  reference  entity  by  the  seller.  If  the  reference  entity  defaults,  the  protection 
seller  pays  the  buyer  the  par  value  of  the  instrument  in  exchange  for  physical 
delivery of the reference instrument, although settlement may also be by cash. 

1.1. 

Risk of negative price spirals 

Short selling can lead to more efficient price  formation  by preventing the  prices of 
securities from reflecting only the views of the most optimistic investors. However, 
especially in distressed markets when financial confidence is lacking, there is a risk 
of short selling creating the impression that there is more supply on the market than 
there really is, and thereby inciting others to sell ('herding behaviour'). This can lead 
to excessive downward pressure on the price of securities. The risk of negative price 
spirals  becoming  self-fulfilling,  which  can  lead  to  disorderly  markets  and  even 
systemic risks, is the main concern of regulators with regard to short selling. 

In addition to short selling on cash markets, derivative transactions such as CDS can 
also be used to secure an economic short position. Buying a CDS without holding an 
underlying  insurable  interest  ('naked  CDS')  is  economically  equivalent  to  short 
selling  a  bond,  as  the  buyer  benefits  if  the  price  of  the  CDS  goes  up.  Several 
governments and regulators in Europe have expressed concerns with regard to CDS 

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and their interaction with bond markets, and the fear that this could cause mispricing 
on bond markets and thus higher funding costs for governments.  

1.2. 

Risk of settlement failure associated with naked short selling 

The risk of the short seller failing to deliver the shares to the buyer by the settlement 
date, as well as a risk of increased price volatility, are the main risks associated by 
some regulators with naked short selling. Data on settlement failures is very limited, 
but suggests low levels in Europe. A majority of regulators said either that they have 
little experience of naked short selling or of related settlement problems, or that the 
risks were limited and could be addressed by settlement discipline. However, some 
regulators  do  perceive  a  risk  of  settlement  failure,  as  well  as  a  greater  risk  of 
increased price volatility, with naked short selling which should be addressed. These 
regulators  expressed  concern  that  in  extreme  cases  naked  short  selling  can  put 
enormous pressure on share prices, which can endanger the stability of the financial 
system. This is because naked short selling enables the seller to sell, in principle, an 
unlimited number of shares in a very short space of time as they do not have to first 
borrow or locate the shares. 

1.3. 

Transparency deficiencies  

In most EU Member States there are currently no disclosure requirements for short 
selling or CDS transactions, so these Member States have no direct access to data on 
the  short  positions  held  in  their  jurisdictions;  although  as  a  result  of  the  financial 
crisis, a number of Member States have introduced different short selling disclosure 
requirements. Regulators have expressed concern that this situation makes it difficult 
for  them  to  detect  the  build-up  of  positions  which  could  have  implications  for  the 
stability  of  markets.  Disclosure  to  the  regulator  could  help  regulators  to  identify 
when  this  is  occurring,  and  deter  aggressive  strategies  which  could  contribute  to 
disorderly markets.  

There is also a risk of information asymmetries between informed short sellers and 
other  less  informed  market  participants.  Disclosure  to  the  market  provides 
information  to  other  market  participants  about  the  price  movements  which  short 
sellers expect and this could improve the efficiency of price discovery. Transparency 
to  the  market  would  also  ensure  that  more  information  about  the  opinions  that 
investors hold on a particular security would be made available to all investors 

Concern has also been expressed by some regulators that speculators may be driving 
down  the  prices  of  government  bonds  by  using  Credit  Default  Swaps  (CDS).  The 
concern  of  these  regulators  is  that  in  the  absence  of  information  about  sovereign 
derivative and bond transactions it is more difficult for them to detect the build-up of 
positions which could cause financial instability, as well as possible market abuse.  

1.4. 

Regulatory arbitrage and increased compliance costs 

jurisdiction  by  carrying  out 

The fragmented responses of Member States to issues relating to short selling leave 
scope  for  regulatory  arbitrage,  as  investors  could  seek  to  circumvent  restrictions  in 
one 
in  another.  This  regulatory 
fragmentation could also lead to increased compliance costs for market participants, 
especially  those  operating  on  several  markets,  who  would  have  to  set  up  different 
systems to comply with different requirements in different Member States.  

transactions 

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2. 

THE BASELINE SCENARIO AND SUBSIDIARITY  

If  no  action  is  taken  at  EU  level  the  problems  defined  above  are  likely  to  remain 
without  a  coordinated  response  and  to  occur  again  in  the  future.  The  European 
Commission  considers  that  the  solutions  proposed  respect  the  principle  of 
subsidiarity.  First,  because  there  is  a  real  risk  of  national  responses  to  short  selling 
and  CDS  being  circumvented  or  ineffective  in  the  absence  of  EU  level  action. 
Second,  such  uncoordinated  measures  are  also  more  costly  to  market  participants. 
Finally, certain aspects of this issue are already partly covered by the acquis, notably: 
the  Market  Abuse  Directive,  the  Transparency  Directive,  and  the  Markets  in 
Financial  Instruments  Directive.  Therefore  a  proposal  on  short  selling  and  these 
existing legal instruments should complement each other.  

3. 

OBJECTIVES  

In light of the analysis of the risks and problems above, the general objectives of the 
legislative  proposal  on  short  selling  are  to  reduce  the  risks  to  financial  stability, 
systemic risks and risks to market integrity arising from short selling and to prevent 
market fragmentation, thereby increasing the efficiency of the internal market. .  

Reaching  these  general  objectives  requires  the  realisation  of  the  following  more 
specific policy objectives: 

(1) 

(2) 

(3) 

(4) 

Reduce  the  risks  of  negative  price  spirals  arising  from  short  positions 
(including those obtained through CDS) 

Increase the transparency of short positions (including those obtained through 
CDS); 

Reduce settlement risk linked with 'naked' short selling; and 

Reduce the scope for regulatory arbitrage and compliance costs. 

4. 

POLICY OPTIONS  

The  policy  options  are  grouped  according  to  the  operational  objectives  which  flow 
from the above-mentioned specific objectives. 

4.1. 

Policy  options  to  ensure  regulators  have  clear  power  to  restrict  or  ban  short 
selling or CDS in distressed markets 

(1) 

(2) 

Option 1 – take no action at EU level. 

Option  2  –  introduce  a  power  for  national  competent  authorities  to 
temporarily restrict short selling in a financial instrument admitted to trading 
on  an  organised  market  whose  price  has  fallen  by  a  specified  quantitative 
threshold, e.g. 10% ('circuit breaker'). 

(3) 

Option  3  –  introduce  a  rule  that  prohibits  short  selling  of  a  financial 
instrument admitted to trading on an organised market except at a price above 

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the last traded price of the instrument, or at the last traded price if that price 
was higher than the price in the previous trade (an 'uptick rule'). 

Option 4 - introduce a ban on 'naked CDS' (i.e. entering into a CDS contract 
without having an underlying insurable interest). Compatible with 2 and 3. 

Option  5  –  grant  national  competent  authorities  the  power  to  temporarily 
restrict  or  ban  short  selling  of  some  or  all  financial  instruments  or  CDS 
transactions  in  exceptional  situations,  with  coordination  by  ESMA  in 
accordance  with  article  6a(5)  of  Regulation  ??/EC  establishing  ESMA,  and 
without  prejudice  to  ESMA's  powers  under  article  10  of  this  Regulation. 
Compatible with 2, 3 and 4. 

Option  6  –  introduce  a  permanent  ban  on  short  selling  of  all  financial 
instruments capable of being sold short. Compatible with 4. 

Option 7 - introduce permanent restrictions or ban on CDS. Compatible with 
2, 3 and 6. 

(4) 

(5) 

(6) 

(7) 

4.2. 

Policy options to ensure regulators and markets obtain data on short positions 
(including through CDS). 

(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

(7) 

Option 1 - take no action at EU level 

Option  2  -  introduce  a  system  of  flagging  of  short  sale  transactions  so  that 
regulators can identify which transactions are 'long' and which are 'short'. 

Option 3 - notification of short positions to the regulator. Compatible with 2. 

Option 4 - disclosure of short positions to the public. Compatible with 2 and 
3.  

Option  5  -  aggregated  disclosure  of  short  positions  (i.e.  individual  short 
positions of investors are not disclosed). Compatible with 2, 3 and 4. 

Option 6 - disclosure of individual significant net short positions. Compatible 
with 2, 3 and 4. 

Option  7  -  exemption  from  disclosure  requirements  for  market  making 
activities and certain primary market operations. Compatible with 2-6. 

4.3. 

Policy  options  to  ensure  certain  requirements  at  the  point  of  trading  and 
strengthen settlement discipline 

(1) 

(2) 

Option 1 - take no action at EU level. 

Option  2  -  introduce  a  requirement  that  before  entering  into  a  short  sale,  a 
person  must  have  borrowed  the  share,  entered  into  an  agreement  to  borrow 
the  share  or  have  other  arrangements  which  ensure  that  he  will  be  able  to 
borrow the share at the time of settlement (locate rule) 

(3) 

Option  3  –  introduce  EU  rules  on  settlement  discipline  so  that  persons 
engaging  in  short  sales  which  result  in  a  failure  to  deliver  face  appropriate 

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penalties,  with  buy-in  procedures  and  fines  in  case  of  settlement  failures. 
Compatible with 2. 

Option 4 - introduce a ban on naked short selling 

Option 5 - exemption for market making activities and certain primary market 
operations. Compatible with 2, 3 and 4. 

(4) 

(5) 

4.4. 

Policy options to ensure a coordinated response by EU member states to short 
selling and CDS 

This  objective  should  be  met  by  the  above  three  categories  of  targeted  options.  In 
addition,  the  choice  of  legal  instrument  should  also  aim  to  ensure  coordinated 
national responses. 

5. 

ASSESSMENT AND COMPARISON OF THE OPTIONS  

The different policy options were tested against the criteria of their effectiveness and 
efficiency in achieving the related objectives. The comparison of policy options lead 
to the following conclusions: 

–  Clear  powers:  the  preferred  option  is  a  combination  of  option  5  (emergency 
powers), and option 2 (circuit breaker). A combination of the two options would 
give  regulators  an  instrument  to  impose  a  short  term  ban  on  short  selling  on 
organised  markets  in  the  event  of  a  significant  price  decline  as  well  as  the 
possibility to impose a temporary ban of a longer duration, capturing derivatives 
as well, in the event of an exceptional situation.  

–  Transparency: the preferred option is a combination of options 2, 3, 4, 6 and 7. By 
combining options 3 and 4, the objective of transparency for both regulators and 
the market would be achieved fully. In addition, a higher threshold for notification 
to  the  market  would  mitigate  any  impact  on  liquidity,  while  ensuring  that 
regulators  obtain  the  data  they  require.  Option  6  (individual  disclosure)  should 
also  be  part  of  the  preferred  option,  as  it  meets  the  objectives  more  fully  by 
providing the market with more detailed transparency. Option 2 (flagging) would 
complement  disclosure  very  effectively  by  providing  regulators  with  real  time 
data  on  all  short  positions,  thereby  capturing  intraday  positions  and  helping 
regulators  with  enforcement.  Finally,  option  7  (market  making  and  primary 
market operations exemption) would ensure that the important liquidity provision 
function of these activities would be able to continue, which would mitigate any 
potential impact on liquidity of disclosure. 

–  Settlement discipline: the preferred option is a combination of options 2, 3 and 5. 
If options 2 and 3 were combined, settlement discipline would be reinforced both 
by  requirements  at  the  point  of  trading  and  by  buy-in  procedures  and  fines, 
thereby meeting very effectively the related operational objective. By combining 
option 5 with options 2 and 3, the potential negative impact on liquidity would be 
mitigated  by  a  harmonised  exemption  for  market  making,  and  so  would  the 
potential  for  regulatory  arbitrage  and  compliance  costs  associated  with  different 
exemptions across the EU. 

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–  Coordinated  response: non-legislative cooperation  is discarded because it would 
not provide an effective solution to uncoordinated national actions leaving scope 
for  regulatory  arbitrage  and  higher  compliance  costs.  A  Regulation  should  be 
preferred  to  a  Directive  as  it  is  immediately  applicable,  would  ensure  uniform 
rules throughout the EU and those concerned by its provisions would be able to 
depend on them immediately. 

6. 

IMPACTS OF THE PREFERRED OPTIONS 

Impact on stakeholders 

Effectiveness 

Efficiency 

Options 2 + 5 
(circuit breaker and 
powers in 
exceptional 
situations) 

Options 2+ 3 + 4 +6 
+ 7 
(flagging, 
notification to 
regulator and 
disclosure to market 
of individual net 
short positions, with 
exemption for 
market makers and 
primary market 
dealers) 

Options 2+3+5 
(locate rule, and 
settlement discipline 
with exemption for 
market makers and 
primary market 
dealers) 

(+++) regulators gain powers to ban 
short selling/CDS in exceptional 
situations and short term  
(+++) issuers' share price can be 
supported by a temporary ban on short 
selling in distressed markets 
(0) governments: reduced volatility on 
sovereign bond markets, but risk of 
negative effects on liquidity 
(- -) financial institutions may be 
temporarily restricted from short 
selling & face compliance costs 

(+++) regulators: full transparency on 
short positions  
(+++) issuers: access to data on 
significant short positions and full 
benefit of liquidity provided by market 
makers 
(+++) individual investors: 
information asymmetries eliminated 
and liquidity provided by market 
makers maintained 
(+++) governments: liquidity in 
sovereign bonds not impaired 
(- ) financial institutions: compliance 
costs and likely to reduce short selling 
to avoid disclosure to public, but can 
continue market making activities 

(+++) regulators can sanction naked 
short selling  
(+++) issuers: number of shares sold 
short cannot exceed the number issued 
or available to borrow, liquidity not 
impaired due to market maker 
exemption 
(+++) governments: number of 
government bonds sold short cannot 
exceed the number issued or available 
to borrow, liquidity not impaired due 
to market maker exemption 
(+ ) some financial institutions may 
have to adapt their compliance 
systems, but market making exempt 

(+++) achieves objective 1 
fully  
(+++) Objective 4: fully met 
(+++) avoids unduly 
negative effects on market 
efficiency  

(-) reduced compliance 
costs due to 
coordinated EU 
approach; any effect on 
liquidity temporary 

(+++) Objective 2:fully met  
(+++) Objective 4: fully met 
(++) limits unduly negative 
effects on market efficiency  

(- ) ongoing 
compliance costs; 
impact on market 
liquidity mitigated by 
thresholds and 
exemption 

(++) Objective of reducing 
settlement risk achieved by 
rules at the point of trading 
and settlement discipline 
(+++) Objective 4: met in 
full 
(+) Contributes to reducing 
risk of negative price spirals 

(-) some ongoing 
compliance costs 
although many already 
operate locate rule; 
impact on liquidity 
mitigated by market 
maker exemption 

7. 

MONITORING AND EVALUATION 

The  Commission  will  monitor  how  Member  States  are  applying  the  changes 
proposed in the legislative initiative on short selling. The evaluation of the legislative 
measure could take place three to five years after its entry into force, in the context of 
a report to the Council and the Parliament on the appropriateness of the reporting and 
public disclosure thresholds.  

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