Short Selling Regulation Review: key points for equities and sovereign debt markets

On 11 July 2023, HM Treasury released the Government response (the “Response”) to the feedback received to its Call For Evidence on the proposed overhaul of the UK version of the Short Selling Regulation (“SSR”), which was published in December 2022. In addition, HM Treasury also released a new consultation paper focused specifically on the deletion of SSR provisions related to sovereign debt and sovereign debt credit default swaps (“CDS”) (the “Consultation Paper”).

The Response and Consultation Paper form part of the comprehensive package of Mansion House reforms announced by Chancellor Jeremy Hunt on 10 July 2023 and the Government’s Smarter Financial Services Regulatory Framework. Please refer to our articles on the other aspects of the Edinburgh and Mansion House reforms, including our article on the Investment Research Review.

In this article we summarise the key outcomes for equities markets discussed in the Response as well as the latest proposals for sovereign debt and sovereign debt credit default swaps (“CDS”) discussed in the Consultation Paper.

On 11 July 2023, the Government indicated in its Plan for Delivery of the Smarter Financial Services Regulatory Framework that it intends to publish a draft statutory instrument (“SI”) before the end of 2023. The draft SI will implement certain changes to the existing framework, while leaving responsibility for the detail of the new regime to the Financial Conduct Authority (“FCA”). The Government has said that it intends to seek technical feedback on the draft SI “where appropriate”, which suggests that industry will have a limited opportunity to put forward any technical drafting changes, without a formal consultation process. This follows the earlier pattern of the “illustrative SIs” that were published when the Edinburgh Reforms were announced in December 2022. The Government then intends to lay the SI in 2024 onwards. Given the detail of the new regime is delegated to the FCA, there will also need to be an FCA consultation before the regime as a whole comes into force.

The consultation period in relation to the Consultation Paper closes on 7 August 2023. Although it is not explicit, we would expect these reforms to be implemented in parallel to the above package.      

Summary of key outcomes for equities markets discussed in the Response

In its Call For Evidence, HM Treasury posed questions on seven central themes. We have summarised HM Treasury’s analysis and responses to the feedback received for each below.

• General regulation of short selling
  • Respondents were unanimously in favour of short selling being regulated, although industry and retail respondents differed on how important they felt short selling was to the health of financial markets.
  • HM Treasury has concluded that:  
    • A full and fundamental reform of the short selling regime is not necessary, but some changes are necessary to create a UK-tailored regime.
    • HM Treasury intends to empower the FCA to create and consult on the detail of a revised regime, which will ultimately be contained within FCA rules, once the current SSR is repealed. The Government will also take action to increase the disclosure thresholds and change the current public disclosure requirements (discussed below). We anticipate that this will be covered by the draft SI.
• Restrictions on uncovered short selling
  • There was overwhelming agreement from respondents that uncovered short selling should be prohibited. However, respondents disagreed over how appropriate existing regulations and arrangements are, particularly on the need for separate covering arrangements for liquid vs. illiquid stocks, and on the actual risk of settlement failure due to short selling.
  • HM Treasury has concluded that the prohibition on uncovered short selling will be carried over as a core principle into the new regime. The Government will also consider feedback on settlement discipline when it replaces the Central Securities Depositories Regulation separately in due course.
• Position reporting to the FCA
  • All respondents agreed that position reporting was important, but respondents (primarily industry respondents) felt that the initial and incremental 0.1% disclosure thresholds (which were moved down from 0.2% during the Covid-19 pandemic period) were overburdensome.
  • There were also suggestions on how the reporting procedure, timing, and sources used for net short position calculations could be improved to make reporting more efficient and less burdensome. Respondents highlighted difficulties with needing to manually input individual position reports into the FCA’s reporting portal, and needing to submit reports by 15:30 on the next trading day. Respondents also highlighted the lack of a “golden source” for total issued share capital for the purpose of calculating net short positions, and the difficulties in the current “negative list” approach to overseas shares (discussed below). The Government has said that the FCA will take into account these points when formulating the new rules.
  • The Government intends to raise the disclosure threshold for reporting positions to the FCA from 0.1% to 0.2%. The FCA will consider the suggestions on operational arrangements when creating the new regime. It will be interesting to see whether there is an improvement in the approach to total issued share capital information, given this also feeds through to the investment research disclosure regime under the Market Abuse Regulation, which also currently presents practical challenges in the production of investment research.
• Public disclosure regime
  • There was no consensus on whether the current public disclosure regime was appropriate and a net positive or negative. Some industry respondents highlighted that the regime enabled copycat behaviour/short squeezes, and discouraged investment in trading strategies, while others praised how the regime provided useful information for liquidity, risk management, and corporate engagement.
  • The Government will replace the current individual position public disclosure regime with an aggregated net short position disclosure model, which in practice will mean the identity of individual short sellers will not be disclosed. The FCA will publish these positions and also make the rules necessary to administer this new model.
• Market maker exemption
  • Industry respondents were overwhelmingly in favour of the appropriateness and efficacy of the current exemption from the reporting, disclosure and “uncovered” trades requirements for market making. Some retail respondents were sceptical and felt that this exemption is open to abuse although this did not appear to be persuasive to the Government.
  • HM Treasury has concluded that the market maker exemption will continue to be an essential element of short selling regulation, and the FCA will consider suggestions on improving it when creating the new regime.
• Emergency intervention powers
  • There was no consensus on whether there was a need to remove the FCA’s emergency intervention powers, particularly the power to ban short selling, but a majority of respondents felt that the FCA should retain these powers for exceptional circumstances.
  • HM Treasury has concluded that emergency powers will be retained, and the FCA will be required to publicly set out its approach to using such powers. The FCA will consult on this approach in due course.
• Overseas shares
  • Respondents raised several issues with the use of a “negative” exemption list, and advocated for a move to a “positive” list that included all shares (both in the UK and overseas) that fall within the short selling regime. Other concerns about the frequency of review, and technical format, of the list were also raised. There is a well-founded concern in the market that the current approach means firms are uncertain as to whether or not particular trades are reportable.
  • All feedback was noted and recognised, and the FCA will consider these issues, including the possible use of a positive list, when drafting the new regime.

Summary of key outcomes for sovereign debt markets discussed in the Consultation Paper

HM Treasury has clearly stated its view that the application of the short selling regime to sovereign debt and sovereign debt credit default swaps (“CDS”), which were leftover when the EU SSR was onshored into UK law post-Brexit, is unnecessary, does not achieve its policy objective and is not aligned with international standards. HM Treasury has highlighted that: (i) the rules were drafted during the European debt crisis, and that the UK was originally opposed to their implementation; (ii) International Monetary Fund and European Securities and Markets Authority studies have illustrated the potential negative impacts on liquidity in sovereign debt markets; and (iii) there are substantial differences in size, volume, and liquidity between the UK’s equity and sovereign debt markets, which mean the regime is inappropriate for the latter.

As such, HM Treasury is proposing to “entirely do away” with the rules as they relate to sovereign debt and sovereign debt CDS, but for the FCA’s emergency intervention powers. HM Treasury has proposed to:

1. remove restrictions on uncovered short positions in UK sovereign debt and sovereign debt CDS (Articles 13 and 14 of the SSR);

2. remove requirements to report sovereign debt positions to the FCA (Article 7 of the SSR);

3. remove requirements to report sovereign debt CDS positions in the case that covering requirements are suspended (Article 8 of the SSR); and

4. amend other parts of the SSR to reflect these changes where necessary.

HM Treasury has asked interested parties to provide feedback within four weeks, i.e. by 7 August 2023, and feedback is to be submitted by email directly to HM Treasury.

If you or your firm would like further guidance on the Consultation Paper or the Report and how your business could take advantage of the potential reforms, please speak to one of our experts.