Short Selling and OTC Derivatives Update

Short Selling

 Following the completion of the European Commission’s (“EC”) consultation on its pan-European short selling proposals which were published in June 2010, the EC has published a proposal on draft regulations on short selling and Credit Default Swaps (“CDS”) (Click Here). These regulations are very similar in content to the June proposals which were set out in our September 2010 newsletter. It is anticipated that the regulation (which will be directly applicable in Member States) will apply from 1 July 2012.

Summary of Draft Regulation on Short Selling

• Two tier disclosure regime for shares (set at 0.2% to the regulator and 0.5% to the market).
• Disclosure to the regulator only for sovereign debt and CDS (the threshold is yet to be decided).
• Restrictions on naked short sales.
• Mandatory buy-in procedures and fines for late settlement at T+4 for trading venues and central counterparties. (T+6 for market making activities.)
• Flagging of all short sales on EU trading venues.
• A new supervisory body – European Securities and Markets Authority (ESMA) - along with competent authorities will have powers to introduce emergency measures in relation to short selling.
• Exemptions will apply where the principal trading venue of the shares is outside the EU, market makers and primary market operators.

OTC Derivatives

The European Commission (“EC”) has been focussing on the regulation of the derivatives markets since the credit crisis began in 2007.  On 15 September 2010, the EC published its proposed Regulation on OTC derivatives, central counterparties and trade repositories (Click Here).  While the OTC markets were not directly responsible for the credit crisis, they are believed to have exacerbated the situation. This was highlighted by the near failure of AIG in part due to its participation in the CDS market.

The OTC derivatives market carries systemic implications for the financial markets due to the use of bilateral contracts which renders them highly opaque, the relatively high level of participant concentration and the close relationship between the pricing of these derivatives and the pricing of other instruments, which could have a detrimental effect on other markets.

The EC’s actions are in line with the commitments made by the G20 leaders at the Pittsburgh Summit in September 2009 which recommended amongst other things, mandatory clearing of all standardised OTC derivatives contracts and the reporting of all OTC derivatives contracts to trade depositaries.

It is envisaged that the Regulation will be in place by 31 December 2012.

Summary of Draft Regulation on OTC Derivatives

• An obligation to clear all eligible contracts with central counterparties (CCPs).
• An obligation to report all OTC derivative contracts to trade repositories.
• Conduct of business and prudential requirements for CCPs.
• Rules on capital and margin.
• Rules on interoperability arrangements of CCPs.
• A default waterfall of funds that CCPs would use on default of a clearing member.
• Authorisation and conduct of business requirements for trade repositories.

15th November 2010