EUROPE - A legislative proposal put forward by the European Commission (EC) today would give the incoming European Securities and Markets Authority (ESMA) permission to make public short selling positions that exceed 0.5% of a company's market value.

Additionally, the new pan-European organisation, which would assume its supervisory duties in January, would have permission to ban short selling for three-month periods, curb naked short selling and regulate the derivatives market more tightly.

However, the International Securities Lending Association (ISLA) has claimed the EC's proposals are too stringent and would threaten market efficiency.

ISLA said that while it supported transparency measures that create disclosure symmetries with long positions, the Commission's proposed public disclosure threshold of 0.5% for short sales was too low.

Kevin McNulty, chief executive at ISLA, said: "Evidence from prime brokers and market studies show short selling activity is artificially reduced by investors seeking to avoid short selling above public disclosure thresholds.

"This undermines market efficiency by reducing liquidity and price discovery, while also widening dealing spreads."

McNulty said ISLA was concerned that a number of the Commission's proposals went "beyond the framework" of the original consultation and were excessive - highlighting naked short selling, flagging of short sales and automated settlement buy-ins.

James Coiley, international finance partner at Ashurst, also sounded a note of caution.
"Although the text of the proposal is fairly balanced, ultimately it permits national regulators and ESMA to ban entry into CDS on as wide or as narrow a basis as they choose," he said.

"So the test will be in the application of the new powers - one man's 'threat to market confidence' is another's rational response to over-leveraged sovereign balance sheets."
His colleague Richard Small, corporate senior associate, said hedge funds would welcome the lower compliance costs.

But he added that the ability of "competent authorities" to impose "potentially indefinite restrictions on short selling" and ESMA's ability to overrule those authorities would be of concern.

"This duality of jurisdiction has the potential to create a level of uncertainty that will not be well received by the hedge fund industry," he said.

Separately, the European Commission has adopted a formal proposal for a directive to regulate the over-the-counter derivatives markets with the creation of mandatory central counterparties (CCPs).

In an impact assessment, the Commission acknowledged the cost of "collateral transformation" when exisitng derivatives contracts are converted to a CCP, but added: "This problem could potentially be solved by allowing CCPs to accept a broader variety of collateral (with appropriate haircuts)."

The European Fund and Asset Management Association (EFAMA) applauded the proposals.

Director general Peter De Proft said EFAMA fully supported the proposals to regulate the OTC derivatives market and a shift from bilateral clearing to central clearing for standardised derivatives contracts.

"A move to mandatory central clearing will have a big impact on all investors and savers, as derivatives are widely used by pension funds, insurance companies and retail fund managers," he said.

"Commission proposals should provide for risk reduction for buy-side investors through effective segregation of collateral and for robust risk management and governance for central counterparties."

He added: "Most important, allocation of the costs for central clearing among market players must be fair, and EU citizens should not shoulder excessive costs with their pensions and savings."