On 20 April, 2012 European Securities and Markets
Authority (ESMA) published the last of its advice on the technical aspects
of the Short Selling Regulation. The regulation, which defines the restriction
on the short selling of shares, sovereign debt and Credit Default Swaps (CDS),
applies from 1 November 2012 and is applicable both inside and outside of the
EU. It overrides the EU national laws on the subject, including, for example,
the German ban on naked sovereign CDS; however, national competent authorities retain
the power to suspend the ban. The European Commission is expected to approve
over the next three months. The European Parliament and the Council have the
right to object to these decisions within three months. This process should not
affect the 1 November date when the law becomes applicable.
The Regulation aims to improve
the transparency of short selling by setting up a regime of notifications of
significant net short positions in sovereign debt, shares and sovereign CDS.
The calculation of what constitutes a net short must include sovereign debt,
sovereign CDS, derivative positions and other sovereign debt correlated (70% or
more) to the sovereign debt in question. The threshold above which a
notification becomes necessary is defined as a percentage of the outstanding
amount issued by the sovereign: 0.1% when the outstanding amount is €500bn or
less and 0.5% otherwise.
Key highlights of regulation:
Ø
Only
naked short CDS transactions executed prior to 25 March 2012 will be grandfathered
and ay be held to maturity. Naked short CDS transactions executed following
that date may need to be covered or closed out prior to 1 November 2012. There
are no grandfathering provisions for uncovered short positions in sovereign
bonds or shares.
Ø
Naked
short positions in sovereign CDS are only allowed for market making and hedging
purposes. With few exceptions, the sovereign issuer used as the hedge must
match the geography of the asset/liability that requires hedging.
Trading sovereign debt and CDS:
What is allowed?
From a trading perspective, the
Regulation defines a new set of restrictions on net short positions in
sovereign debt, sovereign CDS and shares. Essentially, uncovered shorts are banned,
although exemptions apply. The main intent of the Regulation is to restrict
short selling to market making and primary market operations and for hedging
purposes, as follows:
Market making – The Regulation exempts market
makers and primary dealers from the restrictions applicable to the short
selling of sovereign bonds and CDS.
.
Hedging – The Regulation allows short
selling for hedging purposes with limitations as to which hedges
can be used. The naked short in
sovereign CDS is permitted if it aims to hedge (i) the risk of default of a
sovereign entity or (ii) the decline in value of an asset/liability, which is
correlated to such sovereign. Furthermore, investors need to demonstrate (i)
the correlation between the sovereign CDS hedge and the asset/ liability to be hedged
and (ii) the proportionality of the hedge.
To be admitted as a hedge, the
sovereign CDS must generally match the geographical location of the assets or
liabilities the investor wishes to hedge. For example, French corporate risk
with French sovereign CDS and no other CDS, subject to the few exceptions.
Exception to this rule is (i)
when the relevant sovereign CDS is very illiquid; or (ii) when the corporate,
or the risk that needs to be hedged, has strong links to a different sovereign
(in terms of revenue, cash flow, or investment).
Correlation – Hedger will have to
demonstrate the presence of a ‘meaningful correlation’, over a specified time horizon, weighted to the most recent
data (i.e. lastday’s weight is 1/250, second last is 2/250, etc). However, no
minimum level of correlation is set. ESMA recognizes that there are several
other ways to demonstrate correlation, ultimately allowing for considerable
flexibility to ensure that sovereign CDS can be used to hedge a wide range of
assets and liabilities.
Proportionality – The hedger also
needs to ensure that the duration of the CDS is aligned as closely as possible
to that of the risk
Effect of the regulation:
Relative value play –Proposed regulation in it’s
current form diminishes the scope of sovereign CDS as macro hedges or relative
value trades.
Short selling of bonds – The short selling of bonds, on
the other hand, appears less stringent. First of all, an investor is deemed to
be net short sovereign debt if after the addition of all sovereign debt (including
sovereign debt from another member state that has a 70%+ correlation on the
yields), sovereign CDS and related derivatives, the total position is net
short. In this case, however, the regulation does not restrict a short sale
provided that an arrangement with a third party is in place to ensure access to
the bonds if and when needed.
Market implications – The main impact of the shorting
restrictions for Fixed Income will arise, in our view, through reduced use of
sovereign CDS. At present, there are four main user groups of the product:
1)
Dealers
Market-makers take both long and short positions to provide liquidity to other market
participants.
2)
Bank
CVA, correlation and loan desks CVA desks use sovereign CDS to manage bank
counterparty risk. Typically they are buyers of protection. Correlation desks
use sovereign CDS to hedge the mark-to-market risk of derivatives which
reference sovereign entities. Loan desks typically buy protection to hedge
correlated, underlying loan exposures.
3)
Hedge
funds take both long and short positions in sovereign CDS in order to exploit
relative value opportunities across markets or to express directional views on
a particular sovereign or basket of sovereigns (e.g. SovX).
4)
Asset
managers may use sovereign CDS to sell protection to take a synthetic,long risk
position as an alternative to buying specific securities, to buy protection to
hedge underlying exposures and occasionally, to take long or short positions as
part of a relative value strategy.
As we can see, various exemptions
to the shorting ban will likely permit most forms of market making and hedging
activity, while relative value use will suffer the most. However, meeting the
hedging criteria for SovX will be difficult given the cross-border make-up of
the index. Therefore, it is likely that liquidity in the SovX index may be the biggest
victim of the shorting ban. Likely beneficiary of loss of SovX liquidity will
be the use of single-name sovereign CDS as a valid, alternative hedge.
Please see the full technical details put up by ESMA
http://www.esma.europa.eu/system/files/2012-esma-263_-_final_report_on_technical_advice_on_short_selling.pdf
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