Short-selling bans imposed by the US Securities and Exchange Commission (SEC) and UK Financial Services Authority (FSA) could result in reduced structured products business for dealers.
The SEC announced a temporary ban on the short selling of financial stocks on September 19, following a similar move by the FSA the day before. The SEC's rules will remain in force until 11:59pm on October 2, while the FSA's will last until January 16.
"The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets," says Christopher Cox, chairman of the SEC.
In the UK, traders were prohibited from actively creating or increasing net short positions in publicly quoted financial companies from midnight on September 18. The rules cover any instrument that provides a net economic exposure to a financial company, including contracts for difference, futures and options. The ban does not apply if the trade was entered into before September 19.
In addition, the FSA now requires daily disclosure of net short positions in excess of 0.25% of ordinary share capital from September 23 - a move that will massively increase compliance and disclosure burdens on banks and asset managers.
However, the regulations do not apply to market-makers, defined as those firms dealing as a principal in equities, options or derivatives to: fulfil client orders, respond to customer requests to trade or to hedge positions arising from those trades; or provide liquidity to the market on both bid and offer sides in comparable size. The exemption, though, does not extend to bank proprietary trading desks.
While the exemption means dealers will be able to delta-hedge the exposures arising from their equity derivatives business, the rules will have an impact on the structured products offered to customers.
"Because Citi is a market-maker, it can still hedge its positions as an exemption to the FSA's short-selling ban," says Stefan Wagner, managing director, equity structured products at Citi in London. "However, the ban will prohibit some of the equity-linked structured products that investors can buy. For example, those that include absolute return strategies would not be available because their returns depend on a short-selling component."
The regulator stated any economic interest held as part of a basket, index or exchange-traded fund where the main constituents are UK financial institutions would be included in the ban. A short position in an index that doesn't have a large number of financial sector companies, on the other hand, would be permitted. But in anticipation of traders trying to get around the rules, the regulator clarified participants cannot short an index, then go long single stocks in all the constituents other than the financial institutions.
The SEC's rules were similar to those put in place by the FSA. However, dealers were taken by surprise by the apparently limited exemptions for market-makers, prompting some to claim they would have to virtually shut their US equity derivatives businesses. The regulator initially declared the rules were merely delayed until 11:59pm on September 19 for any firm selling short as a result of market-making activities in derivatives referenced to financial stocks or the hedging of positions related to this business.
"It appears from the SEC's statements that US investment banks will not be exempt from the short-selling ban. This means they will not be able to delta-hedge their positions for the duration of the ban. It means banks will have to scale back their equity derivatives businesses because they can't sell certain derivatives, such as put options," noted one head of equity derivatives on the day the ban was announced.
The SEC later brought its rules in line with the FSA, asserting the exemption for derivatives market-makers would continue for the duration of the ban, if related to market-making or hedging. However, market-makers cannot put on a short position if it results in the customer establishing or increasing a net short position after September 22.
Dealers welcomed the clarification. However, as with the UK, the rules will have a knock-on effect on the range of structured products dealers can sell to clients. "It has changed the suite of products we are marketing," says one equity derivatives trader. "We are no longer offering products that offer long/short exposure on a basket that includes financials. Net short positions also cannot be extended within existing products."
Meanwhile, some clients are looking to cancel equity derivatives trades on financial names, citing a clause in the documentation stating a contract can be cancelled if there's a change in the law or if a counterparty cannot hedge. "We are talking to a small number of counterparties about cancelling trades," the equity derivatives trader says.
Regulators in Europe are also looking to introduce short-selling bans of their own, causing concern there may be different interpretations of the rules in various jurisdictions. "Some are using the FSA's rules as a basis, but the rules in some markets are very unclear," the equity derivatives trader says.
Nick Sawyer and Ryan Davidson.