More powers to ESMA

Last September, the European Commission put forward a proposal for a regulation on short selling and certain aspects of Credit Default Swaps (CDS). Such proposal, if adopted, would entail further transfer of powers from national regulators to the new European Securities and Markets Authority (ESMA). The draft regulation will harmonise requirements relating to short selling in the EU as well as the powers that regulators may use in exceptional situations, in case of serious threat to financial stability or market confidence.

The Financial Secretary to the Treasury, Mark Hoban, said to the European Scrutiny Committee that “the Financial Services Authority maintains a disclosure regime in relation to short positions in stocks in UK financial sector companies as a proportionate response to any outstanding or future risk short selling may present;” Moreover, he recall that the Market Abuse Directive already forbids short selling which is carried out in connection with abusive strategies. Moreover, under the Financial Services Act 2010, the Financial Services Authority has powers “to take action against short selling” as well as “to impose a disclosure regime on equities;” Consequently, there is no need for further EU regulations on short selling. The Government does not support the Commission’s proposals on disclosure requirements and restrictions on naked short selling relating to sovereign debt as they are likely to have an adverse impact on sovereign bond markets as well as on a sovereign's cost of borrowing. Taking into account that there is no evidence that short selling of sovereign debt or sovereign credit default swaps has contributed to the financial crisis, the Government is seeking to remove all references to sovereign debt from the proposal. Moreover, according to the Government, the Commission’s proposal “implies significant and unmet ongoing costs for both firms and individuals, trading venues and clearing houses in establishing the infrastructure necessary to meet its requirements.” The Commission has provided no evidence on the need for such proposals and its impact assessment is incomplete, as it does not quantify costs of the risks being addressed.

The European Commission has based the proposal on Article 114 TFEU (approximation of laws), which is the general legal basis for internal market legislation. The Commission has been extensively using this legal base to expand EC competences to the detriment of the competences of the Member States. Measures proposed under this provision are subject to the ordinary legislative procedure with QMV required at the Council.

The Member States were expected to reach a general approach on the Commission’s proposal next Tuesday (15 March). There are considerable divisions among the member states, therefore, an agreement might not be reached just yet. In the meantime, the European Parliament’s Economic and Monetary Affairs Committee voted to toughen the European Commission’s proposals, which is against the UK’s position. It remains to be seen what will come out from the negotiations.The behind closed doors trialogue meetings would be fully used so that an agreement can be reached.

The draft regulation’s transparency requirements will apply to all “natural or legal persons with significant net short positions relating to EU shares and EU sovereign debt” as well as “to natural or legal persons with significant credit default swap positions relating to EU sovereign debt issuers.” Traders that short-sell considerable amounts of shares or government bonds would be obliged to disclose their positions to regulators and to the market. Private disclosure to regulators would be required as regards significant net short positions relating to sovereign debt issuers in the EU. Moreover, a natural or legal person would be required to notify regulators of any significant net short positions in sovereign debt and credit default swaps every time such position reaches or falls below a notification threshold for the Member State concerned or the EU. The Commission would be empowered to introduce measures specifying these notification thresholds.

Under the Commission proposal investment firms would be required to report their short sale transactions as they happened, the members of the European Parliament’s Economic and Monetary Affairs Committee voted for short sale transactions to be reported at the end of each day.

Under the draft proposal, the member states' competent authorities would be required to provide information to ESMA on net short positions relating to shares or sovereign debt, as well as on uncovered positions relating to credit default swaps. According to the European Parliament’s Economic and Monetary Affairs Committee, in case of emergencies, national authorities should be required to provide, within 24 hours, more information to ESMA, if requested.

The draft regulation also provides requirements aimed at addressing the potential risk of settlement failure and market volatility associated to uncovered or naked short selling of shares and sovereign debt. Hence, any natural or legal person may only enter into a short sale of a share admitted to trading on a trading venue or a short sale of a sovereign debt instrument if, at the time of the sale, they have borrowed the share or sovereign debt instrument, have entered into an agreement to borrow the share or sovereign debt instrument, or have made arrangements with a third party in order to ensure that the security can be borrowed. The European Parliament’s Committee voted for forbidden anyone from being involved in credit default swap (CDS) transactions if they do not already own sovereign debt linked to that CDS ("naked" CDS trading). Hence, the MEPs voted to ban trading in credit default swaps related to sovereign debt except the investor already owns sovereign debt linked to those CDS. Obviously, if such provision is adopted traders would be seriously restricted to be engaged in naked short selling of shares.

Presently, the powers of national regulators to restrict or ban short selling vary between Member States. The Commission’s proposal aims to harmonise the national regulators’ powers as well as the conditions and procedures to prohibit or restrict short selling activities. Hence, under the draft proposal, in case of exceptional circumstances, when adverse developments constitute a serious threat to financial stability in a member State or the EU, national regulators would have powers to temporarily restrict or ban short selling in any financial instrument, credit default swaps and other transactions, subject to coordination by ESMA. Unsurprisingly, the Commission will adopt measures, through delegated acts, specifying criteria and factors to be taken into account by competent authorities and ESMA while deciding when the adverse events or developments create a serious threat to financial stability or market confidence.

The Commission’s draft proposal would allow a member state’s competent authority to impose restrictions on credit default swap transactions in exceptional situations. Hence, it may limit natural or legal persons from entering into credit default swap transactions that relate to an obligation of a Member State or the EU, in case of adverse events or developments constituting serious threat to financial stability in one or more Member State and if the measure is necessary to address such threat.

The draft regulation provides for a list of conditions that must be fulfilled before a national regulator can ban short-selling of a financial instrument. Under the draft proposal, member states’ competent authorities would be given the power to impose a temporary prohibition on short selling of a financial instrument, in case of a significant fall in the price of the instrument. Hence, where the price of a financial instrument on a trading venue has during a single trading day fallen by 10% or more, in the case of a share, from the closing price on that venue on the previous trading day, the home member state’s competent authority would have to consider whether it is suitable to ban or restrict natural or legal persons from engaging in short selling of the financial instrument on the trading venue. The competent authority may therefore in the case of a share or debt prohibit or restrict persons from entering into a short sale on the trading venue or limit transactions in the case of another type of financial instrument.

The Commission will specify, through a delegated act, the fall in value for financial instruments other than shares. However, before imposing the measures abovementioned, the concerned member state’ competent authority would be required to notify the competent authorities of the other member states as well as ESMA of the proposed measures. Unsurprisingly, ESMA will “perform a facilitation and coordination role in relation to measures taken by competent authorities.

Moreover, under the draft regulation ESMA would be required to issue an opinion, within one day, stating whether it considers that the adverse events constitute a serious threat to financial stability, whether the proposed measure is suitable to address the threat and whether the duration of the measures is justified. ESMA might also consider that such measures should be taken by other competent authorities. If a national regulator decides to take measures contrary to an ESMA’s opinion it would be required to fully justify its decision.

The Commission’s proposal will transfer the national regulators’ powers to deal with emergency situations to ESMA. Under the draft proposal ESMA may take the same measures as the national regulators. Hence, ESMA would be empowered to require natural or legal persons who have net short positions in relation to a specific financial instrument to notify a competent authority or to disclose such position details to the public. It may also forbid or impose conditions relating on natural or legal persons from entering into a short sale or into transactions relating to a financial instruments or limit the value of transactions in the financial instrument that may be entered into.

It may also restrict natural or legal persons from entering into credit default swap transactions or limit the value of uncovered credit default swap positions that a natural or legal person may enter into relating to an obligation of a Member State or the EU. Under the draft proposal, ESMA would be given the power to take such measures if they are necessary to address a threat to the functioning of financial markets or the stability of the EU financial system, if the situation has cross border implications and if the competent authorities have not taken measures or the measures taken were not adequate to address the threat.

ESMA would be required to notify competent authorities of the measure it proposes. But, the proposed measures will take effect when ESMA publishes on its website notice of any decision to impose. ESMA would be, therefore, empowered to adopt measures with direct effect, limiting or forbidding short selling.

Unsurprisingly, under the draft proposal any measure adopted by ESMA would prevail over any previous measure taken by a national regulator. Hence, in the abovementioned situations ESMA would be able to override measures taken by national regulators.

It is important to recall that the ECJ has decided on the limits to the delegation of powers to agencies in the 1958 Meroni judgment (Meroni & Co., Industrie Metallurgiche, SpA v High Authority of the European Coal and Steel Community). The Court set up a general principle “A delegating authority cannot confer upon the authority receiving the delegation powers different from those which it has itself received under the Treaty.” Moreover, according to the Court the discretionary delegation of powers to bodies which are not foreseen in the treaty would imply a wide margin of appreciation, replacing “the choices of the delegator by the choices of the delegate”, entailing, in this way, “an actual transfer of responsibility.” The Court has stressed that the discretionary delegation of powers to such bodies would infringe the ‘principle of institutional balance.’ The Government noted that the Commission proposed provision conferring on the European Securities and Markets Authority the power to temporarily prohibit or restrict certain financial activities, entails a “wide discretion.” It seems therefore that the Commission’s proposals are not consistent with the Meroni doctrine. According to the European Scrutiny Committee “there is a significant risk that Article 24 is unlawful in that it delegates too much power to the European Securities and Markets Authority, in breach of the Meroni principle.” However, the majority of the member states do not share the Government concerns about the extent of ESMA's powers.

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