SHORT SELLING

A BRIEF HISTORY AND REGULATORY UPDATE

Executive Summary

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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 US?

SEC Regulation SHO

European Short Selling

Regulations

Short Selling Regulation in the

EU

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.

What is Short Selling?

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What is Short Selling?

Short selling is a trading strategy fund managers 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 expected downward price movement, to

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

security.

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

Types of Short Selling

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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.

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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 Co’s 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

Why do Investors Engage in Short Selling?

6 * 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

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How is Short Selling Regulated in

the US?

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

Throughout the years, they have developed and implemented various regulations related to short selling,

including Regulation SHO, which was finalized on August 6, 2004 and has been supplemented in recent

years.

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

according to the SEC:

Short Selling Regulations in the U.S.:

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.”

SEC REGULATION SHO

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 the

following key components:

SEC REGULATION SHO

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

short selling:

Rule 201

Known as the “alternative uptick rule,” Rule 201 was approved in February 2010

as an amendment to Regulation SHO. The rule includes a “short sale-related

circuit breaker,” which is triggered when a security’s 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 –

including information on individual short sale transactions.

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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 implemented independent emergency measures restricting or banning short selling.

As a result, 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 and powers to harmonize regulation across EU member states.

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

European Commission agreed to a final text in October 2011. It was signed on Wednesday, March

14, 2012.

European Union and Member State Regulations:

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European Short Selling Regulations

• Short selling regulation was signed on Wednesday, March 14, 2012.

• The European Securities and Markets Authority (ESMA) developed is draft advice, and

presented it to the European Commission on April 20, 2012.

• The European Commission adopted its final delegated acts and regulatory technical standards

on July 5, 2012.

• The Regulation took effect on November 1, 2012.

European Union and Member State Regulations:

SHORT SELLING REGULATION IN THE EU

The regulation requires reporting of net short positions to regulators over a

certain threshold, and public disclosure of net short positions over a higher

threshold

The regulation further requires parties entering into a short sale to have

borrowed the instruments, entered into an agreement to borrow them or

made arrangements with a third party under which that third party has

confirmed that the share has been located.

Reporting &

Disclosure

Location

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The new regulation covers a number of items1, including:

Transparency &

Restrictions

The regulation also provides competent authorities with temporary power to

require greater transparency or impose certain restrictions on short selling in

emergency situations.

1 The regulation also imposes restrictions on EU sovereign CDS, which are not covered in these materials. More

information on EU short selling regulation can be found here.

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Effects of Short Selling Bans

US and UK Short Selling Bans & the Financial Crisis:

During the height of the financial crisis, several international regulators put in place emergency

measures to restrict the short selling of various financial companies and other securities.

In September 2008, the U.S. SEC issued an Order Halting Short Selling of certain financial securities in

an attempt to “restore equilibrium to the markets.” The SEC acted in conjunction with the UK’s

Financial Services Authority (FSA), which instituted a similar ban.

The ban further deteriorated investor confidence in financial securities and was followed by steep

selling by institutional investors that owned financial securities.*

Up until the SEC Order Halting Short Selling of certain financial securities, the restricted financial

securities were actually performing better than the market.**

The chairman of the SEC at the time publically stated that, in retrospect, it was the “biggest mistake” of

his tenure.***

**The Managed Funds Association, Comment Letter to Jean-Pierre Jouyet, pp. 2, August 13, 2011. **The Managed Funds Association, Comment Letter to Steve Maijoor, pp. 2, August 14, 2011. *”Why Banning Short-Selling Doesn’t Do Any Good.” August 12, 2011. CNBC.com

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*”"The effects of short-selling public disclosure regimes on equity markets,“ Oliver Wyman, pp. 7. **Managed Funds Association, Comment Letter to Jochen Sanio, August 13, 2011, pp. 2. **”Why Banning Short-Selling Doesn’t Do Any Good.” August 12, 2011. CNBC.com

Effects of Short Selling Bans

SEC Short Selling Ban

• Impaired capital raising for

the subject securities;

• Decreased market

efficiency;

• Significantly decreased

trading volume and market

liquidity; and

• Increased bid-ask spreads

from a ―normal average of

17 basis points in 2008 to 60

basis points by October 8,

2008.

Subsequent studies show that the SEC Order Halting Short Selling did not prevent price declines, but

severely degraded the market quality of the subject securities as it:

• Failed to stop the steep price declines (see chart below , from study by Oliver Wyman,* on stock

declines during the U.S. and UK short sale bans – noted in gray);

• Increased volatility;

15 *The Credit Default Swap Market Report, IOSCO.org. **”Watchdog Says Jury out on CDS Short Selling Impact - Reuters

Effects of Short Selling Bans

"To date, there is no conclusive evidence on whether taking short positions on

credit risk through naked CDS is harmful for distressed firms or high-yield

sovereign bonds.“

Short Selling and the European Debt Crisis:

A number of EU member states took regulatory action in 2011 attempting to reduce market volatility

resulting from the sovereign debt crisis. France, Italy, Spain and Belgium instituted temporary bans on

short selling in August 2011. The bans were lifted in February 2012.

The International Organization of Securities Commissions (IOSCO) later issued a report titled “The

Credit Default Swap Market Report,” questioning the role short selling played in CDS or sovereign bond

spread volatility. The report states among the conclusions:

16 ”Letter to ESMA on EU Competent Authorities and ESMA Restricting or Banning Short Selling – Managed Funds Association

MFA Advocacy

Managed Funds Association is constantly monitoring the financial and regulatory landscape and communicating with agencies responsible for rulemaking.

MFA believes short selling plays an important, constructive role in the financial marketplace and that evidence shows short selling bans have proven to be more harmful than beneficial to financial markets. Specifically past experience with short selling restrictions show that:

• Restrictions are counterproductive, further deteriorate investor confidence and increase volatility.

• Restrictions impair the ability of investors to manage risk, which may lead investors to sell additional securities to balance their portfolios.

• Restrictions harm the ability of financial institutions to raise capital through convertible bond and convertible preferred security issuances by preventing - or making it difficult for - investors to hedge the risk with offsetting short sales.*

U.S. Regulatory Agencies:

Securities and Exchange Commission (SEC)

www.sec.gov

European Resources:

1. European Commission

http://ec.europa.eu/internal_market/securities/short_selling_en.htm

2. Council of the European Union

http://ue.eu.int/

3. European Parliament

http://www.europarl.europa.eu/news/en/headlines/

4. European Securities and Market Authority (ESMA)

www.esma.europa.eu/

5. Financial Services Authority (UK)

http://www.fsa.gov.uk/

Additional Resources:

International Organization of Securities Commissions

http://www.iosco.org/

Managed Funds Association

www.managedfunds.org

@MFAUpdates

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References

MANAGED FUNDS ASSOCIATION