A year ago, Oliver Wyman Financial Services published a study relating to the forthcoming regulatory initiatives on short selling disclosure of individual positions breaching certain thresholds in the EU. These requirements have been enacted in parts of the EU and are proposed for broader implementation. The previous study and the current report both present arguments about short selling disclosure of individual positions. The report does not address any issues in relation to anonymous aggregated position disclosure or regulatory reporting to supervisory authorities. In the previous report, we hypothesized that the public nature of these requirements would negatively impact the equity investors’ inclination to engage in short selling and that the subsequent withdrawal of liquidity would have detrimental impacts on equity markets. The results of the study were reviewed with numerous market participants and regulators who were both interested and concerned about the approaches employed during and after the period of market turmoil. The methods and results were discussed fully in order to prompt spirited debate and to ensure the chance for a global dialogue.
At the outset of 2011, these proposals are now far more concrete. The European Commission put forward a Regulation on Short Selling and certain aspects of Credit Default Swaps {COM(2010) 482 final} which proposes that a natural or legal person who has a net short position in relation to the issued share capital of a company that has shares admitted to trading on an EU trading venue must disclose to the public details of the position whenever the position reaches or falls below 0.5% of the value of the issued share capital of the company concerned and each 0.1% above that.
This proposal is now under discussion in the European Council and the European Parliament who are charged with negotiating amendments to the Commission text. It is therefore of utmost importance that the debate in these legislative bodies is based on available empirical evidence.
Based on the industry’s interest in understanding how the markets have evolved, we have therefore revisited our 2010 study to answer two sets of questions:
1. Have the conclusions from the data analysis changed one year later?
2. Have institutional and retail participants in equity markets observed the impacts anticipated?
During the course of our ongoing discussions with the market over the past three months through Q1 2011, we spoke with dozens of participants globally, including asset managers, pension funds, the alternative community, dealers, regulators and independent third parties to obtain their feedback on this topic. We worked extensively with independent data providers to validate these conclusions. To properly gauge reaction, our discussions ranged from small hedge funds to the largest traditional asset managers in the world. So the mixture of interactions was both broad and global.
This year’s study focused on three topics:
- „ Institutional money (institutional investors whose primary client base consists of professional investors)
- „ Macro trends (as evidenced through systematic capital flows)
- „ Retail investors (institutional investors whose primary client base consists of retail investors, with the management of assets via pension funds and insurers)
Within each topic, the impacts on markets fall into three categories:
„
- Market efficiency
- „ Infrastructure
- „ Liquidity
Institutional money segment
Fund managers noted a variety of concerns that they have initially experienced due to the disclosure proposals. Broadly, they have seen liquidity decrease as a result of disclosure proposals and have seen a consequent widening in bid-ask spreads. Certain strategies have identified a pronounced fear of short squeezes in the market, and most participants noted that access to working with corporate management has decreased.
Macro trends
Our research has identified several undesirable asset allocation issues associated with the broader implementation of these proposals. First, investors are already choosing to divert a portion of their alternative investments dedicated to Europe to other geographies rather than accommodate the new proposals. Individuals associated with research, technology, and operations also shift with these investments. Second, traditional equity investments are now beginning to follow those flows. Finally, those with discretionary investments have validated that they are choosing to place their capital elsewhere, where the regulatory environment will allow them the discretion to invest without similar restrictions. In sum, we have seen the beginning in 2010 and continuing in 2011 of investors voting more with their ‘feet’ which we see on balance as an undesirable result of the current rules and which will only be exacerbated if the Commission proposal on short selling disclosures is adopted by the legislators.
Market efficiency impacts
Fund managers expressed concerns that public disclosure of individual short positions would limit corporate management access, which is a key investment decision input for investors. Managers had already experienced such challenges in jurisdictions that had implemented the proposals in the EU to date. In addition, they expected that unsophisticated investors would mimic trades in the market without a full understanding of the strategy. This has occurred already and would become more prevalent as a result of the disclosure proposals. Broadly, investors of all types reiterated their views from last year’s project that there were superior public policy responses to the disclosure dilemma. Market participants were universal in their belief that a compelling case had not been made for public disclosure of individual positions above specific thresholds, but instead argued that they would cooperate with any of a series of approaches involving private disclosure to regulators or an aggregated approach to the public.
Infrastructure impacts
Additional disclosure requirements in the Commission proposal will create an increasingly and unwieldy large amount of new data available to the investing and non investing public, but fund managers doubted that the data would be distilled into anything valuable, timely and understandable. Funds are unlikely to develop new trade ideas from public disclosure filings, as they tend to rely on quality and timely in-house research. Managers believed that funds would need to increase resources to handle additional reporting, but that they were generally well-equipped for the operational burden.
Liquidity impacts
Analysis of market data showed evidence of decreased liquidity, as the research revealed a smaller decrease in bid-ask spreads for equity securities subject to disclosure requirements. For these securities, trading volumes decreased, indicating asset flows into more favorable regimes. In addition, there was a relative decrease in stock borrow volumes and lendable quantity of equities for securities impacted by the guidelines for all types of investors.
Retail investor segment
Some market participants believe that there is an effect on retail investors as well. In this section, we examine the impact to the “man on the street” bearing a potential burden. While not fully conclusive, the research suggests that end investors are impacted by liquidity and market inefficiencies associated with the implementation of these proposals. Using the pension industry as a case study, long only revenues decrease due to loss of stock lending revenues and increased investment costs. In addition, pension investments will likely follow the flow of alternative investment dollars out of Europe.
Conclusions
We develop a series of recommendations for the regulatory community:
„
- The disclosure policy proposals are complicated and will have a substantial and wide ranging impact. Regulators should consider those implications fully as part of the decision-making process
- „ The regulatory approach which is based on the disclosure of individual net short positions above a specified threshold is not effective in meeting the needs of the public, industry participants or regulators
- „ If thresholds are enacted, they should be raised to reflect meaningful ownership interest because public disclosure at low thresholds distorts markets
- „ Public vs. private disclosure and “hot lists” should be considered on a trial basis
- „ For Europe, the most complete approach is a regulatory framework in line with other financial jurisdictions such as the United States and Hong Kong, where private disclosure to regulators and aggregated anonymous public disclosure of, for example, short interest, has proven to be the most balanced solution
The European Commission proposal states in its preamble to the short selling proposal: “The requirements to be imposed should address the identified risks without unduly detracting from the benefits that short selling provides to the quality and efficiency of markets.”
This study will hopefully provide the legislators and decision makers with ample evidence of the dangers the individual position disclosure regime poses to the fulfillment of the stated policy objectives. Market transparency on short positions is desirable and can be achieved more effectively than the current proposals by one of three approaches: anonymous disclosure, aggregated disclosure or raised thresholds.
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