On 15th September 2010 the European Commission published a regulation proposal designed to create a harmonised framework for the short selling of securities across Europe. The regulations aim to manage certain perceived risks, namely:

• transparency deficiencies;
• negative price spirals; and
• settlement failures associated with naked short selling.

The proposals would give authorities the power to restrict or ban short selling temporarily in “emergency situations”; increase transparency to regulators and the market about short selling positions; and reduce settlement risks of uncovered or naked short selling. A number of other provisions proposed go beyond the recommendations made by CESR, including the flagging of short sale trades, the establishment of mandatory buy-in arrangements, and requirements to reserve securities before selling short (as opposed to a locate requirement).

Although, supportive of the move to establish a harmonised framework for short selling we strongly believe that some of the specific proposals are disproportionate to the actual risks being addressed and will have negative consequences for the financial markets and its users.

Short selling is a well-established investment activity, essential for market making and widely accepted by investors and regulators (e.g. IOSCO and CESR) as helping to enhance price discovery, counteract supply/demand imbalances, hedge other positions/exposures and provide liquidity to the market in the relevant securities. Without short selling there would be significantly less liquidity in the markets. It enables financial institutions to purchase specific securities at the time and price of their client’s
choosing by taking on the risk of loss themselves. They can then cover the sale to the client at a later time. Some of the recent proposals and announcements on short selling seem to be based on the misconception that it causes market volatility and is a speculative activity which should be diminished. In fact, studies have shown that banning short selling has resulted in reduced liquidity, increased volatility, wider bid/ask spreads and less efficient price formation. Both the FSA and CESR consultation processes on short sales did not establish that they are more susceptible to misuse than purchases or other types of sales. There is no strong evidence to suggest that short selling was behind the price falls during the crisis of spring 2010. In fact, most of the adverse market movements can be attributed to fundamental factors. In general, short selling is a symptom not a cause of the problem.

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