EU Short Selling Proposals: Brussels at its worst

Buy-Side Features
11 Jul, 2011

“It is better to remain silent and be thought a fool than to speak out and remove all doubt.” Abraham Lincoln’s eloquent dictum still resonates true today, particularly with the European Parliament’s somewhat antagonistic attitude towards the hedge fund industry. Despite the delays and disagreements among politicians, the European Union’s (EU’s) short selling directive could be finalised by July 2012.

If the directive is passed in its present form by member states, it may achieve the double whammy of not only impeding the hedge fund industry’s ability to generate absolute returns for investors, but could also substantially increase market risk. As things presently stand, the rules state that any “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.” It originally called for a total ban on the naked short selling of sovereign debt via credit default swaps (CDS). However, in May 2011 the European Council announced that governments could ask for the ban on naked short selling of government bonds to be lifted if liquidity drops below a certain threshold. Despite the Council’s more moderate stance than the Parliament, there are some tough provisions. If the financial stability or market confidence of an EU member state is threatened, the regulatory authorities could demand further information from investment firms about their trades and impose restrictions on short selling, CDS transactions or limit individuals from entering into derivatives transactions. Funds will also have only one day to cover these shorts or they will incur heavy fines. At best, the proposal is a misguided attempt by a well-meaning European Parliament to curb what they believe to be the systemic risk posed by asset managers in the marketplace. At worst, it is a deliberate, protectionist ploy orchestrated by Brussels’ bureaucrats hell-bent on irreparably damaging the Anglo-Saxon economic model. Either way, this is a worrying time for hedge funds. Fortunately, all is not lost. There are some moderate voices in the European Commission who are hoping to stymie some of the parliament’s more extreme proposals. Whether or not they succeed in this feat remains to be seen.

The fact the European Parliament is even bothering with this initiative beggars belief. The UK’s Financial Services Authority (FSA) report in February 2011 stated quite clearly that hedge funds did not pose a systemic risk to the broader financial markets. Unlike the major investment banks that bought the financial system to its knees in September 2008, hedge funds have generally been absolved of sowing the seeds of the crisis. This is something Robert Mirsky, head of hedge funds at KPMG, feels strongly about. “The short-sellers did not cause the crisis. They had a barely noticeable impact and several reports have said so. The politicians are attacking something they don’t understand. Many people have misconceptions about the function of shorting and its importance in creating efficient markets,” he says. Unfortunately, some officials have failed to heed this point. Politicians have jumped on the populist bandwagon that the Greek and European sovereign debt crisis was exacerbated by hedge funds short selling sovereign debt via CDS. Funds were accused of pushing up the borrowing costs of these indebted countries. This is a flawed argument. Even the European Commission in its December 2010 report on sovereign CDS illustrated CDS spreads “were not leading indicators of sovereign bond yields and that the funds were not responsible after all.” One industry participant who did not want to be named puts it more bluntly – “Greece screwed Greece not the hedge funds.” With this fundamentally flawed thinking among politicians, it is inevitable that elements of the proposal will ultimately be flawed too.

The provisions forcing managers to publicly disclose their short positions when they exceed 0.5% in European companies’ stock appears somewhat misguided. Quite why the figure stands at 0.5% is a mystery given that funds do not need to disclose their long positions until they reach 3%. Matthew Feargrieve, a Switzerland-based partner at international law firm Appleby Global, believes European regulators don’t wholly understand the concept of shorting. “The regulators feel that long positions are more understandable, capable of being explained to retail investors. Managers buy the stock and hope that it goes up - an uncontroversial attitude and one considered to be good for European markets by the regulators. Regulators have traditionally struggled more with the concept of being short a stock, partly because a manager with an uncovered short position can face theoretically limitless losses in a rising market,” he says. Some experts think regulators should at least bring the public disclosure on shorts up to 3% - although quite a few reckon that is still too low. However, other industry participants do not believe the threshold requirements are that onerous. Jérôme de Lavenère Lussan, chief executive officer at consultancy firm Laven Partners, acknowledges that while he is opposed to regulation curtailing shorting, the 0.5% threshold is not unreasonable. “I don’t think the smaller asset managers will be that affected as it is unlikely that they will hold more than 0.5% in short positions of a company’s stock,” he says. The original proposals went as far as demanding individual managers shorting more than 0.5% of European companies’ stock should be publicly named. Thankfully, some common sense prevailed and this “name and shame” idea was recently dropped. While the anonymity is a welcome (albeit not a 100% definite) improvement, public disclosures present a whole raft of problems for fund managers.

“The EU short-selling proposal will result in fund managers having to provide daily short position reporting,” says Anthony Byrne, head of securities lending at Deutsche Bank. “Fund managers will most likely need to take all of their derivatives positions, including convertibles and index futures, and decompose to the individual stock exposure.” Calculating all of these positions could be a significant administrative burden for operations staff. This is just the latest barrage of regulation to hit the industry. Hedge fund compliance teams are certainly facing huge regulatory burdens from both the EU and US. The US Dodd-Frank Act, the EU’s Alternative Investment Fund Managers Directive (AIFMD), the Markets in Financial Instruments Directive II (MiFID II), the UK Bribery Act and the over-the-counter (OTC) derivatives clearing reforms are just a few of the regulatory requirements that will impact hedge funds over the next few years. Operations and compliance teams are going to feel a lot of heat, particularly in smaller outfits. The February 2011 report titled ‘The Effects of Short Selling Public Disclosure of individual positions on Equity Markets’ by management consultancy firm Oliver Wyman outlines some of the issues that could arise for smaller hedge funds. “Smaller funds typically cannot afford the advanced technology that larger funds have in place and they also lack personnel resources in operations and compliance departments. Funds that are less automated will likely have the greatest operational burden to prepare for increased regulatory reporting,” says the report.

The operational costs could be devastating for funds with fewer assets under management given that a chief compliance officer with three to five years experience typically earns between $100,000 to $150,000 per year, according to the National Society of Compliance Professionals 2010 census. Meanwhile, compliance staff with legal or regulatory backgrounds could take home an annual pay cheque of between $300,000 to $500,000. And these are not the only expenditures which the fund will need to fork out for. Research firm Aite Group reveals that incoming reporting requirements from both the US and EU will result in added technology costs for hedge funds. Depending on the fund’s size, complexity and product offering, this could be anywhere between $100,000 and $1 million. For a small business, these reporting and technology costs could be utterly devastating. “In addition to the inherent higher administrative burden, the new proposals also mean that hedge funds will be required to allocate more resources to compliance,” Byrne says. “This is just one more factor that could lead to further institutionalisation of the industry and may have a detrimental impact on some of the smaller players,” he adds. Such expenses will hurt investors at the end of the day as compliance costs will eat into their profits. “These requirements are costly. Managers are going to have to employ people in house and pay others such as compliance professionals and administrators to monitor positions and handle the reporting requirements to ensure reporting obligations are met. This is the latest in a creep of regulation coming out of Brussels apparently designed to place checks and balances on hedge fund managers,” says Feargrieve.

Smaller funds won’t be the only victims of this short-sighted proposal. Systematic and long-only funds could also be hit badly. The Oliver Wyman report highlights “funds with high turnover face operational reporting challenges as a result of trading in and out of positions in thousands of names daily. These funds are critical liquidity providers to the market but they are also likely to reach threshold limits frequently due to their daily high turnover trading and may be faced with an increased operational burden.” Smaller and systematic funds might therefore easily find themselves in non-compliance. Active long-only funds could also be inadvertently caught out by the rules. “A long-only fund manager who is overweight some stocks and underweight others may inadvertently end up in a net short position in stock, whilst shorting futures to manage capital outflows, for example. This means the long only manager may have to have the infrastructure in place to identify whether disclosures need to be made which is clearly burdensome and an unintended consequence,” says Byrne. Some industry experts think the regulators will adopt a no holds bar approach to punishing those who struggle to provide the reporting positions during the early stages of implementation. “Managers are going to need to be disciplined. If they fail to properly make timely disclosures, I feel the regulator will come in and make an example out of them initially. The regulators are showing their teeth on a lot of issues at the moment,” says Phillip Chapple, executive director at consultancy firm KB Associates.

Not only will public disclosure pile on administrative costs to hedge funds, but it could possibly bring about a substantial increase in market risk. Some 69% of managers surveyed in the Oliver Wyman report say they are “concerned” public disclosure would result in short squeezes or “when the market trades on momentum and public disclosure leads to a change in price drivers and other investors exploit this opportunity to create a squeeze on liquidity. If some participants know of others’ short positions, they will be more likely to acquire a stock knowing that covering of the short position will need to take place and thus further raise the stock price, which potentially facilitates a squeeze on liquidity.” Such a scenario could pose a major challenge to market stability.

Approximately 64% of managers surveyed are also alarmed at the risk of copycat trades. This too is an important issue, particularly if less sophisticated investors try to jump on the back of hedge fund managers’ strategies. Roy Zimmerhansl, entrepreneur and securities lending guru, is all too aware of the dangers. “If the personal aggregation of short positions is given out to the public, there is a risk that momentum traders - those without conviction on the asset - could jump on the bandwagon causing greater volatility in the markets,” he stresses. One fund manager cited in the Oliver Wyman report describes the public disclosures as akin to providing people with information “but only giving them half of the story.” Richard Frase, a London-based partner at law firm Dechert, believes these individuals would “piggy-back” vanilla strategies. Nevertheless, he highlights the more complex investment strategies such as arbitrage might not be properly understood by these opportunistic traders. Appleby’s Feargrieve agrees saying: “Managers are, at the end of the day, investment professionals with the technology, understanding and (in most cases) ability to obtain, analyse and act upon market movements and trends. They can identify opportunities and problems in the markets which others cannot”. Less sophisticated investors might not be able to piece together the puzzle as to why a fund manager is short a certain stock. Some managers are merely hedging their exposures by adopting shorts and might not even hold a view on the stock they are shorting. How is an unsophisticated investor meant to know that? This provision could also perversely result in perfectly healthy stocks taking a beating – something the European Parliament, given its reputation for protectionist policies, probably did not envisage.

High-quality (and occasionally groundbreaking) research by hedge funds could also be diminished if public disclosure requirements enable investors or traders, who lack the market know-how, to copy hedge fund trades. Managers have cited the “Warren Buffet effect” whereby people try to replicate the legendary sage of Omaha’s investments for their own financial gain. “There has been a recent growth in websites that combine public hedge fund data with their own analysis to allow investors to trade like ‘smart money’ hedge funds,” says the Oliver Wyman report. Fund managers spend huge amounts of capital and time acquiring top-quality research for trading purposes. Would the likes of Jim Chanos or John Paulson have shorted Enron or sub-prime mortgages respectively if they knew the information would be in the public domain? If an opportunist can simply Google what these astute managers are up to, there is limited incentive to committing so many man hours researching market trends. In many circumstances, the investors won’t know the full story so in turn could lose money themselves. Shorting can even help regulators identify areas of weakness or concern in the market. One industry source says hedge funds did a better job at regulating the markets than the regulators themselves purely because of their excellent research capabilities. “Many short sellers do extremely detailed and thorough research in companies and their findings may help determine whether there has been accounting irregularities, fraud or even systemic risk. This research is a powerful tool that helps regulators and the public. A public disclosure rule creates a strong disincentive for this research to take place and hence ‘kills the canary in the coalmine’,” adds the source. Such an argument reinforces the case for a Hong Kong-style form of disclosure whereby hedge funds privately inform regulators about their short positions. Such a compromise would certainly be welcomed by the majority of fund managers.

If research is diminished, market weaknesses might not be readily identified. Zimmerhansl highlights the EU’s public disclosure proposals could possibly deter fund managers from taking on shorts in meaningful sizes on troubled companies – this, in turn, would artificially distort the market enabling weak (and potentially systemically risky) companies and sovereigns to stay afloat. Derek McGibney, managing consultant at consultancy shop The IMS Group, agrees with Zimmerhansl that the laws could lead to a misreading of market and sovereign stability. McGibney believes the regulations won’t succeed in their original purpose of targeting market abuse. “It could do the opposite and give an improper indication of the way the market is. If that is the case, there is more potential for abuse,” he acknowledges. The proposals could also encourage a net selling effect on European markets. Most hedge funds’ short positions are hedges – many hold long positions in their portfolio. Forced disclosure of shorts could therefore trigger a mass sell-off of hedge funds’ European assets. This is a scenario the regulators would not want.

Another troubling predicament the proposals present is the possibility of hedge funds having diminished corporate access because of public disclosures. Over 85% of funds indicate that corporate access is either “important” or “very important” in the Oliver Wyman report. Without corporate access, hedge funds’ ability to invest becomes significantly harder – as does the capability to generate alpha. This is a serious concern to fundamental long/short managers. “Our whole long/short strategy is based on fundamental analysis where we make multiple visits to corporates we are investing in. These visits are key determinants in our decision-making and as soon as you visibly break trust with a corporate that takes out one of the potential companies you are going to cover,” rues one manager in the report. By disclosing short positions, corporates may become less willing to grant funds access to their businesses– a situation that will further hinder research and distort markets. “The rules could prevent corporates from sharing information with fund managers. If shorts are disclosed publicly, these corporates will not want to find themselves being named in these public disclosures,” warns de Lavenère Lussan. Hedge funds will therefore see a decrease in potential investment opportunities. This policy will hurt end investors – many of whom include public pension funds.

So will these proposed EU short selling rules push funds out of Europe altogether? This is the latest piece of regulation to come out of Brussels making managers’ life that little bit more difficult. Both IMS Group’s McGibney and Deutsche Bank’s Byrne think talk about a mass hedge fund exodus from the EU is overhyped. “The rules could result in hedge funds reducing their exposure to Europe in aggregate but they won’t push hedge funds out of Europe,” says Byrne. Others, however, do not share Byrne’s optimism that funds will stay put. The cost of doing business in the EU is high already, according to Feargrieve. “I think a lot of managers will look at Asia as a jurisdiction. Conceivably, there is a possibility managers could quit the EU because of the increasing creep of regulation. However, lawyers are generally advising their manager clients to adopt a ‘wait and see’ approach, as the rules are not (at this moment in time) set in stone,” he adds.

Disclosing short positions exceeding 0.5% in European stock and the tough rules on naked short selling of sovereign debt CDS is a rushed and downright reactionary initiative from Brussels. Not only does it increase the operational burden on funds and diminish their ability to produce alpha generated returns, it could possibly cause greater market risk. If these rules are passed in their current form, the European Parliament might well be opening Pandora’s Box.