“In light of some global positive signs (…) a tendency to downplay the severity of the current crisis may emerge, accompanied by a reluctance to recognise the need for financial reforms. There is therefore a risk that urgently required regulatory measures are neither fully considered nor implemented in an appropriate way. At the same time, emergent risks might trigger hasty decisions about regulatory measures deemed necessary; a prior and full analysis of the problems involved is, however, essential.”
The quote is taken from the Committee of European Securities Regulators’ (CESR or ESMA1) most recent report on key trends, risks, and vulnerabilities in financial markets. In the text you will find what, in my view, is the great challenge for legislators and regulators in the near future. That is, to urgently adopt the regulatory reforms that have already been extensively diagnosed and discussed on the one hand, while on the other hand resisting the temptation to adopt case-by-case measures without proper analysis. Implementing the much needed regulatory reforms that have been widely studied would in most cases remove the need for case-by-case measures or at least would provide the necessary grounds for a solid basis in their shaping.
This is particularly true in the bond and derivatives markets. We should not forget that, although the current financial crisis had its roots in the US banking sector, it spread worldwide to the whole financial system through the – largely unregulated – bond and derivatives markets (included the so-called structured products). In 2007, these markets were around 10 times the size of stock markets, to which regulators devote most of their time and effort. This was – and indeed still is – not because regulators are negligent, but simply because most of the transactions take place in unregulated markets (basically over-the-counter) on which regulators have no supervisory powers and where trade transparency does not exist. As argued by Goodhart and Somokos (2009), it is now clear that, the situation must change and that regulation and transparency should be extended to all segments of financial markets. More than this, there is a growing consensus that the securities markets may entail systemic risk, which is no longer a matter just for banking regulators. And this is, to my view, one of the key lessons from this crisis.
The previous thoughts are particularly valid for the discussion on short selling and the ongoing discussions on the credit default swap market. The fact is that regulators still know very little on over-the-counter bond and derivative markets and have no access to reliable data on the respective transactions. Even for stock markets, we can find regulatory gaps, for instance, in relation to the identification of short orders. The availability of appropriate supervisory tools is therefore an essential pre-condition for assessing, adopting, and enforcing regulatory measures.
Deep digging on short selling
Let us look then at the short-selling issue in some more detail.
To summarise, we do not see problems with covered short selling in either bonds or equities. However, I believe that regulatory measures on naked short selling should be adopted, as proposed by the European Commission on 15 September 2010.
It is generally accepted by the academic literature that covered short selling improves the functioning of capital markets. According to the analysis of CESR’s Committee for Economic and Market Analysis (2010), allowing covered short selling in general contributes to improved market liquidity, increased market efficiency and less volatile prices. Theoretical and empirical research also shows that covered short selling restrictions may reduce market efficiency and market liquidity, and increase the likelihood of the formation of a bubble, especially when the market is bullish. In adverse market situations (bear markets), the overall effect is not entirely clear, however. While short selling restrictions may reduce high market volatility, the decrease in market liquidity due to the constraints may be very strong when bid-ask spreads are already wide.
Also according to the Committee for Economic and Market Analysis’ work mentioned above, the review of the academic literature shows that naked or uncovered short selling, in theory, is not fundamentally different from covered short selling and, in normal circumstances, is unlikely to have detrimental effects on capital markets. Nevertheless, naked short selling may increase price volatility relative to covered short selling and may have destabilising effects in markets as in theory the number of short sold shares may largely exceed the number of available shares. This is equivalent to artificially multiplying the number of shares in circulation.
A different issue is the misuse of short selling (naked or covered) to manipulate markets (for instance by combining short-selling with spreading of negative rumours or manipulative operations in the cash market). This has to be dealt with by regulators through the application of market abuse rules with proper investigation and sanctions. The question which is left is whether supervisors have all the necessary tools for that. In my view, the answer to this question is not positive, so far.
What should be done?
The means to clearly improve the situation are relatively straightforward: disclosure rules for short positions; a “locate rule” in case of naked short orders; a more stringent settlement regime; and pre- and post-trade transparency in over-the-counter markets. CESR has already proposed a regime of disclosure of short positions both for shares and sovereign bonds. In my view, it would be desirable to complement this regime by an identification mechanism of short orders to supervisors by financial intermediaries (similar to the “flagging” system in the US). This view is shared by the European Commission.
A stringent settlement regime (one that is harmonised across Europe) is also required. Without it, there will generally be an incentive for manipulation, due to the mere fact that there is an opportunity for delivery failure.
All in all, these are more promising ways to prevent the potential negative effects of short selling (covered or naked) than a general ban that risks having negative effects.
There is, therefore (as mentioned by on this site Acharya and Engle 2009 among others), a strong case for improving transparency in bond and derivatives markets, in particular in the over-the-counter sphere, along with accrued supervision in the latter. Debt markets were at the origin of the current financial crisis. The lack of transparency in these markets, which are mainly over-the-counter, to both investors and regulators may have been a decisive contributor to the development of bubbles and the mispricing of risk in those assets. Notwithstanding the measures mentioned above (on short selling of securities), a few structural measures should be urgently adopted at a pan-European level.
To sum up:
- First of all, we need a common regime for post trading transparency and supervision for bonds (including asset-backed securities) and derivatives (including credit default swaps), in parallel with the establishment of a European trade repository, i.e. a centralised registry that maintains an electronic public database of over-the-counter transaction records (including volumes, price and identity). Along the same lines, the duty to report to CESR’s Transaction Reporting Exchange Mechanism should be extended to over-the-counter derivatives (for this, an amendment is needed). From a supervisory perspective, these measures can contribute to accrued supervision of market abuse and of fairness of price, as well as higher efficiency in price formation.
- The second set of measures relates to the clearing of eligible derivatives through central counterparties, which should allow for a decrease in operational risk of market participants. This should go together with an increase in the standardisation of derivatives for easiness of clearing and settlement. From an investors’ perspective, this also increases the number of players quoting prices, thus leading to higher competition, price representation and market integration.
- Finally, the trading of standardised derivatives and structured products in organised markets would very much enhance transparency and information availability to investors. Besides trade transparency, the listing in at least one regulated market would imply publishing detailed regulatory information on issuers and on products themselves, thus contributing to strongly reducing their frequent opacity2.
If, as I hope, courageous reforms are adopted in the short run along these lines, I firmly believe that we will have drawn concrete lessons from the current financial crisis and that we are creating the conditions that will lead to better supervision and more secure markets in future.
Acharya, Viral and Robert Engle (2009), “A case for (even) more transparency in the OTC markets”, VoxEU.org, 29 August.
Acharya, Viral, Thomas F Cooley, Matthew Richardson, Richard Sylla, Ingo Walter (2010), “A critical assessment of the Dodd-Frank Wall Street Reform and Consumer Protection Act”, VoxEU.org, 24 November.
Committee for European Securities Regulators (2010), “Model for a Pan-European Short Selling Disclosure Regime”, CESR 10-088, March.
Goodhart, Charles AE and Dmitri Tsomocos (2009), “Liquidity, default, and market regulation”, VoxEU.org, 12 November.
1 CESR became the European Securities and Markets Authority (ESMA) on 1 January 2011.
2 In the US, the new Dodd-Frank Act requires most standardised swaps to be cleared and traded on regulated exchanges or other trading facilities (swaps execution facilities or SEFs). Such centralised trading venues will increase competition by encouraging market-making and the provision of liquidity by a greater number of participants. A greater number of market makers brings better pricing and lowers risk to the system (see also Acharya et al. 2010 on this site).