1. 1 Regulating Short Selling: The European Framework(s) and the Regulatory Arbitrages Giampaolo Gabbi and Paola Giovinazzo

2. 2 Reading Questions 1. Which is the difference between the regulatory and the fundamental view on short selling? 2. Did all the European countries introduce prohibitions for short sellers after the crisis? 3. Did European Market Authorities introduce a regulation on short selling after the financial crisis in the same time and for the same duration? 4. Is the European regulation on short selling based upon an harmonized framework? 5. Which is the purpose of the short selling regulation in the United Kingdom? 6. Why Germany introduced a restriction on short selling for bonds in January 2010? 7. Which are the main features of the French regulation on short selling? 8. Why the Italian Authority decided to use moral suasion before restricting short selling activities? 9. How short selling regulation has been calibrated in European countries? 10. Which is the impact of heterogeneous regulations in Europe?

3. 3 1. The regulatory view vs. the fundamental view According to the regulatory view, short selling amplifies price collapse when uncertainty and information asymmetries converge towards a negative scenario. This is the rationale by which, financial market authorities introduced different types of bans in order to avoid speculative forces destabilizing financial markets. On the other side, according to the fundamental view short sellers use information to influence the convergence of asset market prices to their fair values.

4. 4 2. European countries decisions after the crisis A majority of European countries introduced restrictions on short selling activities during the months of September and October 2008. Their range and number of restricted assets were partly diverse with different durations. The are some countries that did not introduce any type of restriction on short selling. These countries are the Czech Republic, Finland, Hungary, Poland, Slovenia and Sweden

5. 5 3. When European Authorities introduce their regulation European Countries who decided to introduce short selling restrictions, implemented the ban after the Lehman Brothers collapse The first countries to introduce restrictions, on 19th September 2008 (that is 4 days after the bankruptcy), were Ireland, Luxembourg, Switzerland and the UK. The last country to introduce restrictions was Belgium, on 26th October 2008 On average, restrictions delayed 13 days after the Lehman collapse. This heterogeneity affected the European market equality and the opportunistic behaviour of some financial players

6. 6 4. The European regulation framework on short selling The prohibition of short selling of all stocks listed in the market arises some indirect costs: pricing efficiency, liquidity shortage, foregone profits and consequent trading reduction. Therefore, regulators when introduce such bans need to avoid any type of regulatory asymmetry among countries and financial players. This risk is higher when regulations are managed by agencies with heterogeneous organizations, missions, and supervisory tools. This is what still happens in Europe, where besides a common Financial Markets Directive (aka Markets in Financial Instruments Directive (MiFID), there is at least one supervisory authority for each single country. This could be considered a critical point of the European financial markets, for the existence of many agencies and frameworks where short selling is regulated and supervised

7. 7 5. The purpose of the short selling regulation in the United Kingdom In the UK, the Financial Services Authority (FSA) introduced new provisions to the previous Code of Market Conduct to forbid the formation or the increase of net short positions for both naked and covered short sales in publicly quoted financial stocks. The main purpose is stated as follows: to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector… Financial Services Authority (2008) FSA statement on short positions in financial stocks.

8. 8 6. The rationale of restriction on bonds in Germany On January 18, 2010 the ban for naked short selling on financial stocks was reintroduced for sovereign bonds issued by European countries and for credit default swaps brokers. The purpose was to support bond prices during the Euro crisis and the speculative pressure against Greece. Since this regulation was that it applied only for the domestic market, all banks outside Germany could continue taking short positions on sovereign bonds, however, most of the large banks, decided to manage short selling operations from their foreign offices.

9. 9 7. The main features of the French regulation The French Authority (AMF) wanted to provide as much consistency as possible between the Paris marketplace and major foreign financial centres, in particular those that are home to markets operated by Euronext. Therefore, AMF banned naked short selling and requested that financial institutions abstain from securities lending transactions in financial stocks. Short positions generated through the use of derivatives, such as futures were also banned.

10. 10 8. The effectiveness of moral suasion in short selling The Italian Market Authority (CONSOB) after the Lehman collapse decided to apply the moral suasion as a means of intervention to reduce the activity of short selling. The purpose was to reduce speculative activities against financial stocks during the crisis The impact was considered inadequate for the magnitude of the crisis and, three days later, CONSOB decided to ban naked short selling.

11. 11 9. The approaches to calibrate short selling regulation in Europe The direct approach defines objectively restrictions to short selling by assets and market players, taking into consideration covered and naked short selling; investors activity and specialization; The disclosure approach requires more information on trading activity from financial firms in order to monitor short selling volumes and increase the disclosure. The information can be provided to regulators or directly to the market The mixed approach combines the previous two approaches, in order to minimize the negative short selling impact and supervise more effectively financial speculation. In Europe 4 countries applied the direct approach and 10 countries the mixed approach. Only Italy initially choose the disclosure approach, almost immediately suspended.

12. 12 10. The impact of heterogeneous regulations in Europe While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the Commission would not do it again. The costs (of the short selling ban on financials) appear to outweigh the benefits Christopher Cox, Chairman of the SEC Our study shows that European countries suffered of the disadvantage of a heterogeneous short selling regulation system which induced opportunistic behaviours. The implication is that imperfect harmonization among regulators reduces the expected response of market players and increases the risk of competitive distortions, creating an advantage for a few players.

13. 13 Conclusion This analysis provided insight into: The regulatory framework of short sales in European countries, particularly Germany, France, Italy and the UK The rationales of short sales restrictions in Europe The impact of the short sale prohibition differences in European countries The need for a homogeneous and coordinated set of rules in countries where many financial players can freely settle and operate with a license given by the home country regulator