ESMA: IN A RUSH TO REGULATE

This blog post also appears on TabbFORUM.

Charged by the European Central Bank with writing new short selling regulations, the European Securities and Markets Authority (ESMA), is in a rush. And the need to write these regulations quickly poses potential risks of creating unintended consequences for the wider securities lending market.

ESMA is looking to ensure that there is no naked short selling in the market and to improve market settlement rates and efficiency. Sounds like a good thing, right? On the surface, yes. However, the regulations as proposed could create new costs that outweigh the potential benefits of the safeguards the ESMA aims to introduce. The situation is not unlike limiting a racing car to 5 mph to make sure there are no accidents – it has the desired result but conflicts with the original purpose.

Applying this to the proposed ESMA rules on the securities lending market, it is suggested that borrowers must reserve certain securities not included on a pre-defined list of exceptions in advance of their clients (hedge funds and proprietary desks, etc.) actually going short. Failure to do so would then constitute a naked short.

According to ESMA’s definition of liquidity, securities deemed to have sufficient supply in the lending market are expected to settle securely and not fail, and therefore make it onto the exception list. The borrower, such as a hedge fund, is free to borrow this security to cover a short sale without the need to reserve it from a lender in advance. If the chosen security is not on the list, your broker or borrower has to locate and reserve it at an agent lender or other supplier, prior to you selling it short.

Securities on the list are not exempt from all scrutiny however. “Third parties” (market participants deemed to be competent under the SSR regulations) such as prime brokers, must confirm a liquid security is indeed liquid when it is requested by a client. Such a confirmation would only be valid for that business day, increasing the importance of accurate intraday securities lending activity being available.

Now, hedge funds can seek information such as fee quotes from borrowers on thousands of stocks per day. Under a strict interpretation of the proposed ESMA regulations, this would mean these securities would have to be located and reserved at agent lenders, thereby creating significant extra work and friction in the market, not to mention tying up the supply of arguably already illiquid securities that the hedge fund may not even borrow in the end.

The list of liquid securities is intended to insulate the market from this pain by providing a catalogue of securities that would not need to be located and reserved first. The population of this list is yet to be determined, but the regulations need to be ready by the end of March in time for them to be implemented in the market in November 2012.

Ultimately, the complex new rules to determine whether or not a “locate and reserve” is needed in order to avoid naked short selling will be in place later this year. As proposed, this may be like using a sledge hammer to crack a nut. However, there are even bigger concerns the regulations could become more of a blunt instrument when ESMA only publishes the list of liquid securities annually, which would miss the point of the importance of liquidity in a fast moving marketplace. From a securities supply and demand perspective, this is an area to watch as these regulations take shape – hopefully not the shape of a large, long-handled hammer.

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