COVID-19 Crisis and Bans on Short Selling by European Regulators
By Fahad Al-Sadoon[1]
Introduction
The economic crisis caused by COVID-19 triggered numerous regulatory reactions in the financial sector of the European Union (EU). Bans on short selling are ranked among the most popular but also the most controversial responses delivered by European regulators to tackle the crisis.[2] This response principally derives from the fact that this type of investment strategy is often considered to worsen crises. Nonetheless, this traditional vision is increasingly challenged. In this piece, a definition of short selling is provided, followed by a thorough description of regulatory reactions. This culminates in an exposition of the debate on the benefits and the drawbacks of short selling.
Definition of Short Selling
Regulation (EU) No 236/2012 on short selling and certain aspects of credit default swaps (the regulation on short selling) defines the practice as the sale of a share or a debt instrument which is not owned by the seller at the time of the agreement.[3] It is defined by scholars as an investment strategy where an investor borrows a security (typically from a broker-dealer or institutional investor), at current price and immediately sells it. Later on, when the security’s price (hopefully) declines, the investor buys it back. The investor profits from the difference between the two prices.[4] In other words, investors use this strategy to speculate on the decline in a stock or other securities prices. If broadly used, the strategy concretely induces a decrease in the price of a security. Some might argue that the fact that a significant number of investors are shorting a stock is a genuine indication that the stock is overvalued, while others affirm that massively shorting a stock can turn into a self-fulfilling prophecy on the stock exchange.[5]
The non-consensual character of bans on short selling
Short selling as an investment strategy is subject to a continuous and heated academic debate. The classic approach views short selling as responsible for worsening financial catastrophes. However, a more novel approach considers the practice to be innocuous and even beneficial. In the following section the two opinions shall be discussed.
According to the classic approach, unbridled short selling has been blamed by governments and some economists for exacerbating volatility during times of stress.[6] Indeed, some would say that it can contribute to price declines in the securities of financial institutions in a manner that is unrelated to the true price valuation.[7] Some extreme forms of short selling can even use false rumours in order to manipulate the market and obtain the targeted (reduced) price.[8] In relation to this view, a plethora of regulators in several countries temporarily banned short selling on certain stocks during the financial turmoil of 2008. This was undertaken in order to improve investor confidence and reduce volatility.[9] The current reaction seems to be a confirmation that European Regulators have not changed their opinion and still fear short selling during times of crisis. However, since the 2008 crash, bans on short selling have been faced with strong opposition for a number of reasons.
Firstly, bans are incompatible with price efficiency.[10] An extremely desirable feature of the financial market is fairness: no one shall pay for a share more than its real value.[11] Eugene Fama stresses the importance of the price in the realisation of the efficient market. The market is efficient when prices ‘fully reflect available information.’[12] Based on this assumption, markets should operate in a transparent manner making information available to all players at the same time. In efficient financial markets, the prices of financial assets reflect all available information,[13] favourable and unfavourable. When investors engage in short selling, they provide information. They are the ones revealing to other market participants that the price of security is overrated, inducing a readjustment in the price. Thus, market efficiency is increased. Banning short selling can possibly hinder the communication of a correct information to market participants that reveals the genuine price of a security.
Secondly, short selling is beneficial as it increases liquidity on the market. Investors engaging in short selling supply liquidity to the market by increasing the number of sellers in the pool.[14] Significant market liquidity can accordingly be provided by market professionals (such as investment firms). Consequently, those market professionals can compensate temporary imbalances in the supply and demand for securities.[15] Indeed, short selling adds to the trading supply of stock available to purchasers and reduces the probability that the price paid by investors is artificially high because of temporary contraction of supply.[16] By that logic, bans on short selling can jeopardise the economy by reducing liquidity on the market.[17]
Thirdly, some studies question the effectiveness of short selling bans. These researchers have described short selling bans on financial stocks as a factor that increased the probability of both default and volatility in the targeted companies and financial institutions.[18] It can also create an increase in bid-ask spreads and in the Amihud illiquidity indicator, controlling for other variables.[19]
Current developments
Certain European Regulators believe that the outbreak of Covid-19 pandemic is responsible for substantial selling pressure and unusual volatility in the price of shares of financial institutions.[20] As a consequence, some investors might be tempted to take new positions in order to profit from a future price decrease. Such action may, in turn, accelerate the fall in price already experienced in the preceding days. Consequently, it can seriously aggravate the current economic disturbance.
One of the many legal tools European regulators have is the regulation on short selling and certain aspects of credit default swaps. This legislation aims at harmonising the rules applicable to short selling across the EU and clarifying the powers of competent regulators.[21] It is enforceable throughout the EU, without the need for further legal thinking by any Member State.[22]
Thus, different approaches were embraced by the following regulators:
- The Financial Services and Markets Authority (FSMA) of Belgium, pursuant to article 23 of the Regulation (EU) No. 236/2012 of the European Parliament (SSR),[23] decided on 16 March 2020 to prohibit for a period of 24 hours the short selling in shares that lost 10% or more of their value on the same day.[24] This measure is similar to a Circuit breaker mechanism, which is generally considered to be fairly effective and consensual. Then, on 17March 2020, pursuant to article 20 of the aforementioned regulation, the prohibition was generalised and extended until 17 April 2020 by the FSMA.[25]
- The Autorité des marchés financiers (AMF) of France,[26] the Comisión Nacional del Mercado de Valores (CNMV) of Spain,[27] the Hellenic Capital Market Commission (HCMC) of Greece,[28] and the financial markets regulator (FMA) of Austria[29] introduced a direct a ban on short selling for a one month period pursuant to article 20 of the Regulation (EU) No. 236/2012. This was performed without enacting a prior circuit breaker mechanism.
- The Commissione Nazionale per le Società e la Borsa (CONSOB) of Italy, pursuant to the same article 20, introduced a ban directly but for a period particularly longer than the others. The Italian ban on short selling entered into force on 18 March 2020 and was expected to expire after the close of the trading session on 18 June 2020.[30]
Those prohibitions shared the same common factor that they applied regardless of the place where the transaction is executed (for example on a trading venue or Over the Counter); they also, were all potentially renewable. Indeed, by 15 April 2020, all the aforementioned national regulators renewed their ban until 18 May 2020.[31]
Relevantly, other European countries such as the Netherlands and Germany did not undertake any particular regulatory strategy to limit short selling and do not signal any particular fear towards the practice.
The European Securities and Markets Authority (ESMA) delivered a positive opinion on the bans. According to ESMA, those prohibitions are justified by the current adverse events that constitute a serious threat to market confidence and financial stability.[32] On 16 March, ESMA delivered a decision that temporarily requires holders of net short positions in shares traded on an EU regulated market to notify the relevant national competent authority (NCA) if the position reaches or exceeds 0.1% of the issued share capital after the decision was implemented.[33] In other words, ESMA lowered the threshold for reporting short selling and investors such as hedge funds, will accordingly have to give regulators more information about the securities they are betting against.[34]
In the context of short selling bans and the Coronavirus crisis, it is interesting to note that pursuant to article 27 of The Regulation, ESMA has a competence to coordinate the action of regulators in different member states in order to ensure that a consistent approach is adopted. Considering the exceptional circumstances,[35] ESMA can also issue a general ban on short selling pursuant to article 28 of The Regulation.[36] The Austrian regulator, FMA, as well as Markus Ferber, a German senior member of the European Parliament, stated on 18 March that they would have preferred the ESMA to have enacted a pan-EU ban.[37] However, such decision seems to be disproportionate as the virus has not impacted all members states in the same way.[38]
On 18 May 2020, ESMA stated that Austria, Belgium, France, Greece and Spain will not renew the bans on short selling, which expire on the same day, and Italy is lifting its ban earlier than the scheduled date of 18 June.[39] The AMF stated that ‘Since the implementation of the ban, Markets have partly reduced their losses, trading volumes and volatility have returned to levels that are still high compared to mid-February’.[40]
Conclusion
During the current financial crisis, short selling has returned to the regulators’ agenda. This has also provoked a resurgence of debate surrounding the controversial questions on its efficiency. From the variety of reactions from European Regulators, one can conclude that the issue remains divided on the European level. Nonetheless, it seems inevitable that any future answer must incorporate an approach that balances the benefits and the costs of short sale.
[1] I would like to thank Prof. Veerle Colaert and Drs. Tom Vos for their comments on an earlier draft of this text.
[2] Philip Stafford, Laurence Fletcher and Robert Smith, ‘Regulators across Europe clash over bans on short selling’ the Financial Times (London March 31 2020) < www.ft.com/content/14a95d33-b4db-4a9a-a4e4-834a45c23228> accessed 29 May 2020.
[3] Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps OJ L 86, 24.3.2012, article 2, §1, (b).
[4] Robert Battalio, Hamid Mehran, and Paul Schultz, ‘Market Declines: Is Banning Short Selling the Solution?’ (Federal Reserve Bank of New York Staff Reports, no. 518 September 2011) <www.newyorkfed.org/medialibrary/media/research/staff_reports/sr518.pdf > accessed 29 March 2020.
[5] ibid.
[6] Alessandro Beber and Marco Pagan, ‘Short-Selling Bans Around the World: Evidence from the 2007-09 Crisis’ (2013) 68 the Journal of Finance 343.
[7] ibid 344.
[8] Markus K Brunnermeier and Martin Oehmke, ‘Predatory Short Selling’ (2014) 18(6) Review of Finance 2153.
[9] Securities and Exchange Commission, 2008 – 211, ‘SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets’ (Securities and Exchange Commission, 2008 – 211) <www.sec.gov/news/press/2008/2008-211.htm> accessed 29 March 2020.
[10] Robert P Murphy, ‘A Man, A Plan, and a Short-Selling Ban’ (2008) Library of Economics and Liberty <www.econlib.org/library/Columns/y2008/Murphyshortsell.html> accessed 29 March 2020.
[11] Eugene F Fama, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 The Journal of Finance 384.
[12] ibid 383.
[13] ibid.
[14] Piero Cinquegrana, ‘Short Selling: A known unknown’ (2009) ECMI Papers 1671, Centre for European Policy Studies.
[15] ibid.
[16] Christopher A Stanley, ‘The panic effect: possible unintended consequences of the temporary bans on short selling enacted during the 2008 financial crisis’ (2009) 4 Entrepreneurial Business Law Review 367.
[17] ibid.
[18] Jamie Powell, ‘Against the short-selling ban’ the Financial Times (London 18 March 2020) <https://ftalphaville.ft.com/2020/03/18/1584523654000/Against-the-short-selling-ban/> accessed 18 March 2020.
[19] ibid.
[20] FSMA, ‘Prohibition of Short Selling’ (Press release of the Financial Services and Market Authority of Belgium 17 March 2020) <www.fsma.be/en/news/prohibition-short-selling-update-19032020> accessed 18 April 2020.
[21] Rodolphe Elineau, ‘Regulating Short Selling in Europe after the Crisis’ (2012) 8(2) International Law & Management Review 66.
[22] ibid 66.
[23] Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps OJ L 86, 24.3.2012, article 23 <https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:02012R0236-20140917&from=EN> accessed 18 April 2020.
[24] ESMA, ‘Opinion of the European Securities and Markets Authority of 15 April 2020’ (Opinion on the proposed emergency measure by the Financial Securities and Markets Authority under Section 1 of Chapter V of Regulation (EU) No 236/2012) <www.esma.europa.eu/sites/default/files/library/esma70-155-9833_opinion_on_fsma_emergency_measure_under_the_ssr.pdf> accessed 18 April 2020.
[25] James T Moser, ‘Circuit Breakers’, (Federal Reserve Bank of Chicago February 1990) <file:///c:/users/colsh/appdata/local/packages/microsoft.microsoftedge_8wekyb3d8bbwe/tempstate/downloads/ep-sep-oct1990-part1-moser-pdf%20(1).pdf> accessed 18 April March 2020.
[26] ESMA, ‘Opinion of the European Securities and Markets Authority of 15 April 2020’ (Opinion on a proposed emergency measure by the Autorité des marchés financiers under Section 1 of Chapter V of Regulation (EU) No 236/2012) <www.esma.europa.eu/sites/default/files/library/esma70-155-9854_opinion_on_amf_emergency_measure_under_the_ssr.pdf> accessed 18 April 2020.
[27] ESMA, ‘Opinion of the European Securities and Markets Authority of 15 April 2020’ (on the proposed emergency measure by Comision Nacional del Mercado de Valores under Section 1 of Chapter V of Regulation (EU) No 236/2012) <www.esma.europa.eu/sites/default/files/library/esma70-155-9845_opinion_on_cnmv_emergency_measure_under_the_ssr.pdf> accessed 18 April 2020.
[28] ESMA, ‘Opinion of the European Securities and Markets Authority of 15 April 2020’ (Opinion on the proposed emergency measure by the Hellenic Capital Market Commission under Section 1 of Chapter V of Regulation (EU) No 236/2012) <www.esma.europa.eu/sites/default/files/library/esma70-155-9853_opinion_on_hcmc_emergency_measure_under_the_ssr.pdf > accessed 18 April 2020.
[29] ESMA, ‘Opinion of the European Securities and Markets Authority of 15 April 2020’ ( Opinion on a proposed emergency measure by the Austrian Finanzmarktaufsicht under Section 1 of Chapter V of Regulation (EU) No 236/2012) <www.esma.europa.eu/sites/default/files/library/esma70-155 9848_opinion_on_fma_emergency_measure_under_the_ssr.pdf > accessed 18 April 2020.
[30] ESMA, ‘Opinion of the European Securities and Markets Authority of 17 March 2020’ ( Opinion on a proposed emergency measure by the Commissione Nazionale per le Società e la Borsa under Section 1 of Chapter V of Regulation (EU) No 236/2012) < www.esma.europa.eu/sites/default/files/library/esma70-155-9565_opinion_on_consob_emergency_measure_under_the_ssr_all_shares.pdf > accessed 18 April 2020.
[31] ESMA, ‘Short Selling’ (press release, 16 April 2020) <www.esma.europa.eu/sections/short-selling> accessed 19 April 2020; This statement does not apply to the Italian regulator since its ban covers from the beginning a long period going until the 18 of June 2020.
[32] ESMA, ‘Opinion of the European Securities and Markets Authority of 15 April 2020’ (Opinion on the proposed emergency measure by the Financial Securities and Markets Authority under Section 1 of Chapter V of Regulation (EU) No 236/2012) <www.esma.europa.eu/sites/default/files/library/esma70-155-9833_opinion_on_fsma_emergency_measure_under_the_ssr.pdf> accessed 18 April 2020, §14-16.
[33] ESMA, ‘Decision of the European Securities and Markets Authority of 16 March 2020’ (Decision that requires natural or legal persons who have net short positions to temporarily lower the notification thresholds of net short positions (…) in accordance with point (a) of article 28(1) of Regulation (EU) No 236/2012 of the European Parliament and of the Council) <file:///C:/Users/colsh/AppData/Local/Packages/Microsoft.MicrosoftEdge_8wekyb3d8bbwe/TempState/Downloads/esma70-155-9546_esma_decision_-_article_28_ssr_reporting_threshold%20(1).pdf> accessed 19 April 2020.
[34] Anna Menin, ‘EU watchdog tightens short-selling rules as coronavirus sell off worsens’ CITYA.M (London, 16 March 2020) <www.cityam.com/eu-watchdog-tightens-short-selling-rules-as-coronavirus-sell-off-worsens/> accessed 29 March 2020.
[35] Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps OJ L 86, 24.3.2012, art 27.
[36] ibid art 28.
[37] Asad Jafri, ‘Austria bans short-selling; parliamentarian asks ESMA if EU-wide ban needed’, SPG Global (New York, 19 March 2020) <www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/austria-bans-short-selling-parliamentarian-asks-esma-if-eu-wide-ban-needed-57665363> accessed 20 March 2020.
[38] The European Parliament, ‘The economy and coronavirus – Weekly Picks 27/04/2020’ (Briefing of the European Parliament 20120) <www.europarl.europa.eu/RegData/etudes/BRIE/2020/645740/IPOL_BRI(2020)645740_EN.pdf> accessed 3 January 2020.
[39] ESMA, ‘Short Selling’ (press release, 18 May 2020) <www.esma.europa.eu/sections/short-selling> accessed 29 May 2020.
[40] AMF, ‘The AMF suspends the ban on the creation or increase of net short positions’ (press release, 18 May 2020) <www.amf-france.org/en/news-publications/news-releases/amf-news-releases/amf-suspends-ban-creation-or-increase-net-short-positions> acessed29 May 2020.