Short Selling: A Brief Overview and Regulatory Update

Managed Funds Association February 2014

SHORT SELLING

A BRIEF OVERVIEW AND REGULATORY UPDATE

2

Short Selling

Contents

Executive Summary

What is Short Selling?

How Does Short Selling Work?

The Benefits of Short Selling

How is Short Selling Regulated in

the U.S.?

Regulation SHO

European Short Selling

Regulations

Short Selling Regulation in the

EU

Short Selling Bans

Effects of Short Selling Bans

MFA Advocacy

References

2

3

5

6

7

8

10

12

13

14

16

17

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.

Executive Summary:

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.

4

What is 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).

Types of Short Selling:

5

How Does Short Selling Work?

John Doe holds 100 shares of XYZ Co. - valued

at $25 per share – as a long investment position.

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.

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.

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).

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.

BORROW 100 shares ABC @$25/share

SELL 100 borrowed shares ABC @$25

PROFIT FROM SALE of ABC shares = $2500

BUY 100 shares ABC@$20

RETURN 100 shares ABC to lender

COST TO PURCHASE 100 shares ABC @$20

= $2000

LOSS on100 shares XYZ =

-$500

PROFIT from short sale of ABC shares =

$500

100 SHARES XYZ = $2500 VALUE

6

* SEC Securities Lending and Short-Selling Roundtable : 9/29/09-9/30/09

The Benefits of Short Selling

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

How Does Short Selling Affect Markets?

7

How is Short Selling Regulated

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:

Source: http://www.sec.gov/spotlight/keyregshoissues.htm

• 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.”

Short Selling Regulations in the U.S.:

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.

Broker-dealers must close-out any outstanding failure-to-deliver positions

(“open-fails”) by the settlement day, following the settlement date.

Locate

Requirement

“Close-out”

Requirement

8

Regulation SHO applies to short sales of equity securities and includes,

among others, the following key components:

MFA generally believes Regulation SHO is an effective approach to the

regulation of short selling in the U.S.

Regulation SHO

9

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 sale-

related 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

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.

Short Sale Data

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.

Regulation SHO

10

European Short Selling 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).

European Union and Member State Regulations:

11

European Short Selling 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.

European Union and Member State Regulations:

European Short Selling Regulations

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.

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.

Reporting &

Disclosure

Location

12

The new regulation covers a number of items,* including:

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.

13

Short Selling Bans

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. **The 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

U.S. and UK Short Selling Bans and the Financial Crisis:

14

*”"The effects of short-selling public disclosure regimes on equity markets,“ Oliver Wyman, pp. 7. **Managed 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

Effects of Short Selling Bans

• 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.

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;

SEC Short Selling Ban:

15

Effects of Short Selling Bans

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.

Short Selling and the European Debt Crisis:

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.

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/

Additional Resources:

International Organization of Securities Commissions

http://www.iosco.org/

Managed Funds Association

www.managedfunds.org

@MFAUpdates

17

MANAGED FUNDS ASSOCIATION

References