EU Short Selling Regulation (SSR)

The SSR applies to the short selling of all securities admitted to trading in the EU, sovereign debt instruments as well as credit default swaps (CDS).

Short selling is the practice of selling a security the seller does not own at the time with the intention of buying it back at a later at a lower price. There are two types of short selling activity, covered and naked shorting. Covered short selling involves borrowing the securities before the sale, whilst naked short selling is where the seller has not borrowed securities prior to the sale.

A credit default swap (CDS) is a derivative contract which acts as a form of insurance against the risk of credit default of a corporate or government bond. In return for a series of payments, the credit risk is transferred from the buyer to the seller. If the issuer defaults, the CDS seller pays the buyer the face value of the instrument. An uncovered or naked CDS is when the buyer of a CDS is not exposed to the credit risk of the underlying reference entity.

The key provisions of the SSR are as follows:

• Prohibition of naked short selling of shares and sovereign debt instruments (ie uncovered short sales) and naked CDS;
• Significant net short positions must be reported to the relevant authority when they reach 0.2% of the share capital, and every 0.1% above or below that on an EU trading venue.
• Net short positions greater than or equal to 0.5% of the share capital must be publicly disclosed;
  National regulators have powers to temporarily restrict short selling in response to a significant price fall or in response to a serious threat to financial stability or market confidence (short selling ban);
• Exemptions are available for market making activities and authorised primary dealers.

Following both long term and short term short selling bans adopted during the COVID-19 crisis, ESMA undertook an analysis of the impact of these measures on market liquidity, returns and volatility, and whilst results were inconclusive, ESMA found that short selling bans were associated with liquidity deterioration (increased bid-ask spreads) and that the bans did not harm or sustain market prices during the period. In March 2022 ESMA produced a Final Report to the EU Commission of its finding after a systematic review of the SSR provisions and has proposed some targeted changes which includes record keeping arrangements for securities lending locate arrangements. There have been no further developments since the Final Report.

Securities Lending itself is not captured under SSR, however securities lending forms a key part in the process of permitted short selling. A short sale can be covered by a securities lending transaction if the securities are delivered to the borrower, prior to the short sale as per Article 12 (1)a of the EU SSR.

Whilst there are varying opinions on the usefulness of short selling activity and related short selling bans, ISLA believes that short selling is a crucial contributor to efficient capital markets by increasing liquidity, improving market stability, and promoting price discovery. In 2019, ESMA released a Report on ‘Undue short-term pressure on corporations’, in which it states:

‘ESMA has considered the general arguments in relation to the impact of short-selling and securities lending practices and their potential link with short-termism. Nevertheless, ESMA points out that short-selling and securities lending are key for price discovery and market liquidity. Moreover, ESMA is not aware of concrete evidence pointing to a cause-effect connection between these practices and the existence of undue short-term market pressures. Additionally, the Short Selling Regulation foresees the right of NCAs and ESMA to adopt emergency measures that may even restrict the capacity of market participants to sell short financial instruments temporarily where a threat to the financial stability or to market confidence may exist.’

ISLA monitors the short selling regulations through its Regulatory Steering and Market Practice Steering groups and advocates that short selling is conducted with a regulatory framework to ensure market integrity. To enable short selling to fulfil its pivotal role within the capital markets ecosystem it relies heavily on the availability of securities from securities lending programmes to allow market participants, to execute short sales and implement effective hedging strategies and therefore ISLA speaks to this topic with regulators and market participants. ISLA views covered short selling is a legitimate and widely used trading technique that plays a crucial role in maintaining market efficiency, facilitating better price discovery and underpinning market liquidity. Short selling can correct market inefficiencies and act as a stabilising mechanism by bringing over-inflated stock prices back to their true market value, through allowing investors to express sentiment against overvalued stocks.