European rules on shorting could harm hedge fund strategies and investors

Short solutions

The nightmares hedge fund managers were having about potential regulations emanating from Brussels may have lessened but the danger is not over yet. Rules covering shorting of sovereign debt and European equities are still boiling away although some of the more extreme measures have fallen by the wayside.

For example, provisions that could have forced short sellers to identify themselves publicly when a short position on any European Union (EU) company hit 0.5% of share capital have been ditched.

However, fund managers say many of the rules proposed by the European Commission and endorsed by vote of the European parliament’s economic and monetary affairs committee will damage some strategies and make others more expensive, if not impossible, to run.

The rules will also hurt capital markets, international trade and the EU as a financial centre, they claim.

The proposed rules need now to be agreed by EU member states before becoming law, probably in July 2012.

The new rules will be overseen by the European Securities and Markets Authority (Esma) which, as the successor to the committee of European Securities Regulators, wins significant powers under some of the provisions.

The new rules on shorting have provoked controversy from the outset, with 124 submissions from governmental and private bodies during the public consultation phase last summer.

First is a rule prohibiting the taking of naked short positions in sovereign debt via credit default swaps (CDS). Managers must inform regulators but not disclose the position publicly when a net short in any EU company hits 0.2% of its share capital. Funds will have only one day to cover shorts or else incur fines “sufficiently high to prohibit any profits being made”.

A hedge fund’s prime broker must locate and reserve the securities its client wishes to short – called ‘hard-locate’ – before the position can be taken. Finally, Esma gains extensive powers for emergency bans of shorting and its ability to co-ordinate vetoes across Europe.

“Before you ban anything or take significant measures you have to make sure the adverse consequences are not worse than what you’re doing, and it is proportionate and there are safeguards,” confirms Sharon Bowles, chair of the economic and monetary affairs committee.

“It is a worrying time for the City but an awful lot of the problems have been about getting people to understand shorting has a good side but most people do not know what that is, that it was short sellers that exposed Enron, for example. People only hear about the bad bits,” adds Bowles, a Liberal Democrat member of the European parliament (MEP).

Matthew Magidson, chair of the derivatives practice group at lawyers Lowenstein Sandler, says short sellers are an easy political target “but it becomes much harder when you realise much of the money at play is being managed on behalf of the same pensioners who could lose their pension in a financial meltdown”.

The European Commission says shorting is a legitimate financial practice useful to provide liquidity. However, the parliamentary committee says European regulators fear naked shorting could cause mispricing of debt and “extreme price pressure” causing downwards spirals.

Shorting has been wrongly blamed, claim hedge funds, for pushing up borrowing costs for indebted countries such as Greece. During the eurozone’s 2010 debt crisis, as yields on debt rocketed, Greece enacted curbs on naked shorting of public debt.

Lowenstein’s Magidson says the “actual ‘culprit’ appears to have been Greek banks hedging their exposure to Greece. This legislation would have made little, if any, difference in the Greek turmoil but might actually have had an adverse impact on the market by reducing participation and leading to price inefficiencies.”

The commission argues national watchdogs need transparency about equity shorting levels in Europe in order to be able to spot systemic risks and abusive shorting. Brussels would then also require powers to curb shorting in extremis.

Some say the private reporting obligation alone could force primarily long-only investors such as pension funds – certainly not the chief targets of the rules – to ascertain if they breach any net short threshold, even if only to satisfy in-house compliance and regulators that they have not.

“The calculation [of net shorts] is complex and a multi-product portfolio needs significant infrastructure support. We can help funds with estimates [of net short exposures] which should be helpful to demonstrate a prudent second check in the event of regulatory inspections,” notes Anthony Byrne, European co-head of global prime finance at Deutsche Bank.

“As soon as you go short a sector future – especially in indices with big weightings in small companies – you could be in breach, and you will have to have systems to work out if you did or not,” he adds.

The industry was relieved that only private disclosure appeared in the rules, not public reporting.

Jiri Krol, director of policy and government affairs at the Alternative Investment Management Association (Aima), had branded open disclosure “a remnant of a draconian response to the nervousness [of short selling in the financial crisis] that we never felt was justified.”

Practitioners point to numerous academic studies, including some cited by the EU itself, which found bans and public reporting put into effect in at least 14 countries at the height of the financial crisis failed to stop market falls.

A report sponsored by Deutsche Bank and conducted earlier this year by Oliver Wyman said: “There has been no justification shown for public disclosure from a market efficiency or systemic stability perspective. On the contrary the negative effects include decreased market efficiency and a higher risk of disorderly markets as a result of ‘herding’ when reputable large hedge funds enter visible short positions.”

One prime broker warns open disclosure could have caused hedge funds to reduce aggregate shorting activity in order to fall below the public radar. By doing this they would fail to act as “canaries in a coalmine. These funds are the best way to find out the systemic problems.”

David Williams, partner and head of the UK investment funds practice at law firm DLA Piper, notes faulty measures of short interest could still appear because holdings in convertible bonds and similar securities are excluded from calculations of net shorts.

Private reporting to regulators, while “less objectionable” than public disclosure, is “perhaps equally as pointless”, says Williams.

“What are regulators going to do with this information? Ban shorting in certain circumstances? There is, at best, uncertainty as to whether the bans on financial institutions in the early stages of the financial crisis had any beneficial effect and it may indeed have been harmful. Further, the absence of information about motives underlying shorting will make the regulator’s job even harder,” Williams continues.

“Disclosure will be of relatively little value, whether public or private, in terms of preventing market abuse. The vast majority of shorting activity is non-abusive and entirely necessary for the efficient functioning of the market. Requiring disclosure simply adds bureaucracy to a regulatory regime which already has no shortage of red tape,” he concludes.

Aima’s members have “no problem with adequate regulation of naked short selling of shares,” says Krol. “Harmonisation of short selling measures is a very positive step, so we will not have to deal with a number of disparate short selling regimes around the EU again.”

Some 13 EU national watchdogs apply six different thresholds for short disclosure of equity or CDS positions.

 “Hedge funds are not angels of death, they are often looking for strong long trades, not just shorts and they can ramp up a long with leverage,” notes Rob Mirsky, KPMG’s head of hedge funds. He believes the Brussels provisions “appear part of broader market restrictions including the alternative investment fund managers [AIFM] directive. It gives a feel of ‘fortress Europe’. It is very dangerous for the competitiveness of Europe, and in particular London as Europe’s financial centre.” He predicts start-ups could simply avoid Europe in future.

“If I am highly mobile and can trade wherever I want, and am not a US citizen tied by tax, I can move to Hong Kong [whose regulator] SFC [Securities & Futures Commission] is reasonable in a jurisdiction with reasonable tax rates,” he argues.

Arguably, Brussels’ harshest move was only allowing shorting of sovereign debt via CDS by funds that hold a countervailing long economic interest in the same debt.

Andrew Baker, Aima’s chief executive, says “it makes little sense to single out one particular derivative contract” for such restrictions while Krol adds it is effectively unreasonable to prescribe why investors may enter derivatives contracts.

This sentiment was echoed in the consultation submission from Volkswagen, which argued it needed to be able to place shorts via CDS for the country exposure risk it assumes in doing business.

“It should be recognised many companies have commercial credit exposure that is frequently insured by the use of CDS. Non-financial institutions should not be prohibited to hedge this risk,” the carmaker said.

 “A lot of derivatives are cash settled so you do not have the delivery issues as with securities. Second, I think we now have overwhelming evidence from official and academic sources it was not CDS market activity that caused sovereign debt problems in the EU,” remarks Aima’s Krol while Baker adds: “There should be recognition of the fact that the market cannot function properly without liquidity providers, who may enter in and out of the contact without hedging any underlying risk exposure.”

The useful provision of liquidity hedge funds offer through shorting was one key focus of the Oliver Wyman study.

The Risk Institute at French business school Edhec says the effect of banning naked CDS shorts could be felt further afield than just financial markets. Countries will find it difficult to manage interest rate risk on their debt actively because counterparties would be barred from hedging the country risk of interest rate swaps they had entered into, Edhec says.

One banker notes: “It will be harder for sovereigns to issue debt because it is less attractive if the regulations [around CDS] are quite similar to taking away the ability to hedge markets.”

Financiers of public or private entities that conduct business with sovereign bodies could find it impossible to hedge against default risk. “At a time when public-private partnerships and private financing of public infrastructure projects are considered one of the drivers of global growth, making it harder to manage country risk may at the very least increase the costs of these partnerships and this financing,” Edhec says.

Lowenstein’s Magidson says the moratorium on naked shorting of public debt also makes life difficult for strategies investing based on relative spreads between corporate credit and debt in one jurisdiction or on relative spreads of different pieces of debt.

The rules around CDS are not, however, the only provisions that practitioners point to as possible hindrances of common hedge fund strategies.

They argue the hard-locate rule, forcing banks to find and reserve securities before clients sell short, will also cause harm in particular to quick-fire strategies such as statistical arbitrage.

 “Systematic funds with high turnover face operational reporting challenges as a result of trading in and out of positions in thousands of names daily. These funds are critical liquidity providers to the market, but they are also likely to reach threshold limits frequently due to their high turnover trading,” says the Oliver Wyman study.

One industry practitioner says  it would be the “man in the street” who would suffer if fast-trading hedge funds do less business because such retail investors are the ones who make use of the market liquidity that fast-paced funds offer.

The rules will make fast-trading strategies more expensive to implement and bid/offer spreads could widen. “The lower the costs, the more viable these strategies are but of course the managers prefer spreads that are fractions of a basis point, so they can turnover very quickly,” says one bank.

“If the fast-trading sector finds it difficult to generate alpha in certain markets, those managers will stop operating those kinds of strategies. HSBC AI has about 2% in fast-trading managers,” notes Tim Gascoigne, head of global portfolio at HSBC Alternative Investments which has $28 billion invested in hedge funds.

The rationale behind hard-locate, counters the EU, is to reduce the chance of trades failing if securities are not delivered.

One banker says there are only a negligible number of occasions in a year a ‘fail’ happens with clients and “if we had a client shorting and not then making good, you would have words with them. But that said, the market self-regulates well.”

Krol says Aima’s members “are absolutely in favour of shares being delivered when they are supposed to be delivered but an existing market practice where a fund relies on the services of a prime broker should be enough to ensure that. We haven’t seen vast amounts of unsettled trades as a result of short selling activity, and this is why the burden of proof should be on those who wish to significantly alter current working arrangements.”

A final set of provisions within the rules grant Esma wide-ranging powers. The body will be able to restrict short selling but only temporarily and only if various pre-conditions are met. It will also co-ordinate any short-term curbs by Europe’s state regulators, for example 24-hour bans on instruments that fall significantly in one day.

When necessary, but with checks and balances, Esma will also encourage international co-ordination on any restrictions beyond Europe’s borders.

 “This type of joint effort is likely to become increasingly prevalent,” says Magidson. “However, it may be difficult for regulators in different jurisdictions to agree on any appropriate outcome. Just within the US, the Commodities Futures Trading Commission and Securities & Exchange Commission have yet to be able to agree on over-the-counter derivatives regulation. It would seem even harder also to have consensus with European regulators.”

On balance, concludes HSBC’s Gascoigne, the new regulations “will be positive for the industry because it will decrease the perception hedge funds are risky entities.”