Short Selling: A Brief Overview and Regulatory Update

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For those hoping to learn more about this important function in our markets, this new presentation offers helpful information on what short selling is and how it works, different types of short selling, and provides an overview of the regulatory actions taken both in the U.S. and in Europe. Other topics covered in the presentation include: The benefits of short selling and how it is used as a hedge How short selling is regulated in the United States A brief overview of current EU short selling regulations The economic effects of short selling bans in the U.S. and Europe An overview of MFA’s global advocacy on short selling issues

Text of Short Selling: A Brief Overview and Regulatory Update

  • Managed Funds Association February 2014

    SHORT SELLING

    A BRIEF OVERVIEW AND REGULATORY UPDATE

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    Short Selling

    Contents

    Executive Summary

    What is Short Selling?

    How Does Short Selling Work?

    The Benefits of Short Selling

    How is Short Selling Regulated in

    the U.S.?

    Regulation SHO

    European Short Selling

    Regulations

    Short Selling Regulation in the

    EU

    Short Selling Bans

    Effects of Short Selling Bans

    MFA Advocacy

    References

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    Short selling is a strategy used by investors to balance

    portfolio allocations and manage risk. It also performs

    a number of important roles in the marketplace aiding with price discovery and providing much-needed

    liquidity.

    This presentation offers a brief overview of short

    selling, the benefits it provides for investors and the

    marketplace, and how it is regulated in the United

    States and European Union.

    Executive Summary:

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    What is Short Selling?

    Short selling is a trading strategy fund managers and other investors employ when they

    believe that shares of a particular stock are overpriced.

    It generally means borrowing a security (or commodity futures contract) from a broker

    and selling it, with the understanding that it must later be bought back (hopefully at a

    lower price) and returned to the broker.

    The short seller closes out the short position by purchasing equivalent securities on the

    open market, or by using an equivalent security it already owned, and returning the

    borrowed security to the lender.

    Short selling can be used to profit from an anticipated downward price movement, to

    provide liquidity, or to hedge the risk of a long position in the same security or in a related

    security or other type of long exposure.

    Source: http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm.

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    What is Short Selling?

    In covered short selling, the investor has made arrangements to either borrow the securities or to

    ensure that they can be borrowed to perform the transaction.

    A naked short sale is one in which the investor does not own the securities at the time of the sale and

    has not made arrangements to borrow them in time to make delivery to the buyer within the standard

    three-day settlement period.

    If the seller does not deliver shares within the required time frame, that is known as a failure to deliver. A failure to deliver generally does not occur in a covered short sale because an investor has ensured

    that shares can be borrowed and delivered.

    MFA consistently supports regulatory proposals

    in the U.S. and Europe that are designed to

    prevent naked short selling (except in limited

    circumstances, such as market making).

    Types of Short Selling:

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    How Does Short Selling Work?

    John Doe holds 100 shares of XYZ Co. - valued

    at $25 per share as a long investment position.

    Mr. Doe is worried about XYZ Cos upcoming earnings report, however, and decides to offset this long position by

    selling short ABC Inc. stock - which is in the same market

    sector as XYZ Co. and would likely also lose value should

    XYZ report poor earnings.

    Mr. Doe makes arrangements to borrow 100 shares of

    ABC Inc. stock at $25 per share and immediately sells it in

    the marketplace netting $2,500. Mr. Doe must return the

    borrowed shares at a specified date.

    As anticipated, the earnings report is negative and XYZ Co. and ABC Inc. stocks both decrease in value to $20 per share.

    Mr. Doe buys back the quantity of ABC Inc. stock needed to cover his short position (100 shares at $20 per share for a

    total cost of $2,000).

    Mr. Doe has earned a profit of $500 on the short sale and offset the decrease in value of the long position held in XYZ Co.

    BORROW 100 shares ABC @$25/share

    SELL 100 borrowed shares ABC @$25

    PROFIT FROM SALE of ABC shares = $2500

    BUY 100 shares ABC@$20

    RETURN 100 shares ABC to lender

    COST TO PURCHASE 100 shares ABC @$20

    = $2000

    LOSS on100 shares XYZ =

    -$500

    PROFIT from short sale of ABC shares =

    $500

    100 SHARES XYZ = $2500 VALUE

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    * SEC Securities Lending and Short-Selling Roundtable : 9/29/09-9/30/09

    The Benefits of Short Selling

    The ability to quickly blend positive and negative information into share prices is essential

    for markets to work efficiently.

    Short selling provides the following benefits in the marketplace:*

    Increased liquidity Increased capital formation Improved price discovery, which bolsters investor confidence Decreased transaction costs (e.g. smaller bid-ask spreads) Decreased occurrences of price bubbles and / or crashes Efficient risk allocation Hedging against long term investment positions

    How Does Short Selling Affect Markets?

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    How is Short Selling Regulated

    in the U.S.?

    The SEC is the government agency tasked with regulating securities markets in the U.S.

    Throughout the years, the SEC has developed and implemented various regulations related to short selling,

    including Regulation SHO, which it finalized on August 6, 2004 and has supplemented in recent years.

    Regulation SHO was adopted under the Securities Exchange Act of 1934 to meet the following goals,

    according to the SEC:

    Source: http://www.sec.gov/spotlight/keyregshoissues.htm

    Establishing uniform locate and close-out requirements to address problems associated with failures to deliver, including potentially abusive naked short selling.

    Creating uniform order marking requirements for all equity securities sales, requiring participants to label orders placed with broker-dealers

    as long, short, or short exempt.

    Short Selling Regulations in the U.S.:

  • Regulation SHO requires a broker-dealer to have reasonable grounds to believe the specified security can be borrowed so that it can be delivered on

    the due date before executing a short sale. Broker-dealers are required to

    document the location before making the transaction.

    Broker-dealers must close-out any outstanding failure-to-deliver positions

    (open-fails) by the settlement day, following the settlement date.

    Locate

    Requirement

    Close-out Requirement

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    Regulation SHO applies to short sales of equity securities and includes,

    among others, the following key components:

    MFA generally believes Regulation SHO is an effective approach to the

    regulation of short selling in the U.S.

    Regulation SHO

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    Regulation SHO has been amended since implementation in 2005 to include new rules governing

    certain aspects of short selling:

    Rule 201

    Known as the alternative uptick rule, the SEC approved Rule 201 in February 2010 as an amendment to Regulation SHO. The rule includes a short sale-related circuit breaker, which is triggered when a securitys price declines by 10 percent or more in a day. Once triggered, short selling of that security is only

    permitted if the price is above the current national best bid.

    Rule 201 applies to all equity securities listed on a national securities exchange,

    regardless of whether they are traded in an exchange or over-the-counter markets.

    Rule 204

    In July 2009, the SEC amended Regulation SHO to include Rule 204 to reduce

    fails-to-deliver and curb abusive naked short selling. The SEC developed this rule in response to persistent fails to deliver in the marketplace, penalizing firms if they do not close out fails in a timely fashion.

    Short Sale Data

    Several self-regulatory organizations (SROs) provide daily aggregate short selling

    volume in formation on their websites and on a one-month delayed basis,

    information regarding individual short sale transactions in all exchange-listed

    securities. All of this information can be found on the SECs website: http://www.sec.gov/answers/shortsalevolume.htm.

    Regulation SHO

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    European Short Selling Regulations

    European nations traditionally regulated short selling individually, rather than collectively through the

    European Union (EU). For example, during the financial crisis in 2008, several EU member states

    independently implemented independent emergency measures restricting or banning short selling.

    Subsequently, the European Commission released a proposed regulation in September 2010 related to

    short selling and certain aspects of credit default swaps (CDS). The proposal introduced common

    requirements for EU Member States and powers to harmonize regulation across Member States.

    After months of negotiations among the European Parliament, the Council of the European Union and

    the European Commission, a final text was agreed to in October 2011, and it was officially signed on

    March 14, 2012 by MEP Martin Schulz, the President of the European Parliament, and Nicolai

    Wamman, the EU Affairs Minister of Denmark (which held the rotating presidency of the Council of the

    European Union).

    European Union and Member State Regulations:

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    European Short Selling Regulations

    Short selling Regulation w