Race to the Finish as Euro Short-Selling Ban Nears

As of November 1, the European Securities and Markets Authority (ESMA) will enforce a ban on naked short-selling of shares and sovereign debt, alongside stricter rules on transparency.

While most incoming regulation is subject to lengthy debate and editing before implementation, this particular mandate has been relatively swift. ESMA's initial consultation on the subject surfaced on January 24 of this year, leaving just a little over nine months for firms to respond.

"I think if I could have changed anything, it would have been the timeline," says Matt Gibbs, product manager, Nothern Europe, at investment management software vendor Linedata. "I think the timeline both for the equity and the debt is far too tight. If you're going to make very wide changes, and the amount of system requirements and architecture that you've got to put in place to support them is significant, that cost always goes down to the end consumer. And then you have to bear in mind whether the cost outweighs the risk mitigation and protection they're going to get from the new regulation, and that's a tough question. Only time will tell, but for my mind it does seem very rushed in."

Procedural Concerns
As a result, Gibbs says he is concerned that a lot of firms are going to end up on spreadsheets, with little capacity to automate the process without significantly investing in new data governance tools.

The European regulation, which will enter member state statute books as supreme law, bans trading in instruments such as credit default swaps (CDSs) without ownership of the associated bonds—known as a naked short sale. The strategy has had a negative reputation among regulators given its role in the financial crisis, and the ban on naked short-selling for sovereign debt is widely seen as a protective move against the current European sovereign debt crisis.

There's an awful lot of data and there's an awfully short time to put these things in place. Plus of course then just the physical reporting mechanism has to be put in place, because over-reporting is frowned upon as well as under reporting. It's quite a task.

Another unfavorable potential outcome of the new regulation, says Gibbs, could be the difficulty with which firms will be able to report their net positions.

"You're going to need to have procedures in place to ensure that you have an official way of locating stock that you can put down in place pre-trade or pre-going short," he says. "I think with proper written documentation between yourself and whoever you're borrowing from, you can do a lot of that, but that whole process pre-trade has to be in place. You also then need to have a way of recording where you are going short, what your previous reporting position was, and a way of referencing that previous reporting position against your daily change. And then, of course, you've got additional reporting requirements as you go through."

Hard Labor
Essentially, this is no small piece of work, says Gibbs, highlighting a requirement for firms to have a calculation of net shorts that encompasses 12 months' worth of historical evidence on how tightly correlated the instruments' pricing is—not necessarily the type of data all buy-side firms may have readily available.

"There's a 12-month history of an instrument that they may not have held and that is going to be quite an undertaking if they're going to go down that route," he says. "I think they'll probably just come up with a much more simplified version internally of what's accessible and what's not, and they'll just go with that. But there's an awful lot of data and there's an awfully short time to put these things in place. Plus, of course, then just the physical reporting mechanism has to be put in place, because over-reporting is frowned upon as well as under-reporting. It's quite a task."

The Bottom Line

• Only a little over two months remain before ESMA enforces its ban on naked short selling of shares and sovereign debt.

• Tighter disclosure rules are also part of the November 1 package, leaving investment firms with much to consider—not to mention implement—and little time in which to do it.