18/01/2012 Author: Will Wainewright

Adapting to change

As the specifics of the EU restrictions on naked short-selling of credit default swaps become clear, the hedge fund industry is now setting about the task of assessing the impact of the new proposals in time for their introduction in November this year

The EU’s plan to regulate short-selling, and, most notably, ban uncovered shorting through credit default swaps (CDS) on sovereign bonds, is nearing fruition. The regulation – passed by the EU Parliament two months ago and expected to be given the seal of approval in the EU Council before the end of the month – is due for introduction on 1 November this year.

Regulators have a habit of targeting shorting activities when markets are rocked by volatility, and, given the scale of Europe’s sovereign debt crisis, they were always going to act. That several countries took action independently as the on-going European debt problems escalated into outright crisis during August certainly helped fuel the political fire.

The hedge fund industry, however, has largely doubted that an EU-wide ban of any kind would improve matters – indeed, by restricting liquidity in such key markets, they could get worse.

Andrew Shrimpton, regulatory compliance member at Kinetic Partners, told HFMWeek the counter-productive nature of such bans was shown by how the yield on French bonds exploded following the announcements last year. “This has been made worse by the reduced liquidity in the French bond market,” he said. “Short-selling is a symptom of markets falling, not a general cause,” adds one industry participant.

Nonetheless, funds have just ten months to prepare for the regulation and work out how the restrictions may limit their operations. Restrictions on uncovered – or ‘naked’ – short sales will be the biggest restraint, and mean short-sellers must have some form of ownership of stock they are shorting. This will apply to the shorting of sovereign debt too, although the restrictions are more relaxed to ensure the liquidity of debt markets.

The use of naked sovereign CDS is all but banned, although, as revealed in last week’s issue of HFMWeek, there remains some uncertainty in the industry about its introduction. Although the legislation doesn’t come into force until November, those uncovered sovereign CDS purchased between its entry into the EU’s Official Journal – due for the end of January – and its debut won’t be carried across, or ‘grandfathered’, beyond 1 November. This is a fact that “a lot of managers won’t have appreciated yet,” according to Neil Robson, regulatory specialist at Schulte, Roth & Zabel.  

The other side of the new regulation applies to disclosure of shorting activities. Once an investor holds a net-short investment equivalent to 0.2% of a company, the relevant national regulator must be informed, while all net-short positions worth 0.5% must be made public. This is an unpalatable prospect for hedge fund managers keen to protect their commercial advantage.  

Peter Moore, the IMS Group’s head of regulation and compliance, says: “The setting of these harmonised disclosure thresholds, which are much more sensitive on the short side than they are on the long, mean that many more investment strategies will result in the public exposure of sensitive position information. This could be problematic as other participants may copy their strategy or otherwise try to make life difficult for them with the knowledge of their position. Accordingly, such thresholds will directly influence trading.”

The public disclosure element of the new regime introduced by the regulation looks like it may actually be the least threatening part of the new regulation, as Schulte’s Neil Robson points out: “Many EU countries currently have a disclosure regime broadly comparable to the rules coming into force in November anyway, so the regulation, with regard to the shorting of EU equities, will probably not cause a massive change of tactics for most hedge fund managers.”

He adds that many of his hedge fund clients have cautiously welcomed the regulation, “as it will provide managers with certainty as to what the rules are in all 27 of the EU markets.” Peter Moore agrees that the new harmony between national regimes could make it easier, overall, for hedge funds to operate.

Time will tell. In the meantime, hedge fund managers – those in fixed-income arbitrage in particular – have another set of regulatory measures to get their heads around. As with 2011, the year ahead looks certain to provide its share of regulatory challenges.