House of Representatives

Explanatory Memorandum

Circulated by the authority of the Minister for Superannuation and Corporate Law, Senator the Hon Nick Sherry

Chapter 5 Regulation impact statement

Policy objective

5.1 There has been significant speculation in recent months regarding the activity of short sellers in Australian listed securities. Short selling is an activity where a person enters into an agreement to sell a security that the person does not currently own. Short sellers need to make arrangements to cover their delivery obligations to the buyer before they fall due (usually three trading days after the transaction is executed). This is normally done by:

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making a matching purchase at some point following the sale but before delivery falls due; or

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borrowing an equivalent amount of securities before delivery falls due, either before they enter into the sale or at some time between making the sale and when required to make delivery.

5.2 There are two types of short sale transactions: naked and covered. A naked short sale occurs when a seller does not own and has not borrowed or arranged to borrow securities at the time of sale but intends to purchase or borrow securities in order to meet the delivery obligation. A covered short sale occurs when the seller has entered into an agreement to borrow the security in order to meet their delivery obligations prior to entering into the arrangement to sell the security.

5.3 Currently, short selling of Australian securities is prohibited under the Corporations Act 2001 unless a person has a 'presently exercisable and unconditional right' to vest the product at the time of sale. The prohibition is subject to a number of exemptions, which permit short selling in a defined range of circumstances. The most commonly used exemption allows a person to enter into naked short sale transactions subject to some conditions imposed by the Australian Securities Exchange (ASX) through its Market Rules. These conditions place a limitation on the range of securities that can be subject to naked short sales and requires disclosures surrounding these transactions. Reported end of day net-short positions reported to ASX are between 0 and 2 per cent of share trading volume.

5.4 In relation to covered short sale transactions, market practice has developed so that these transactions avoid the prohibition in the Corporations Act on the grounds that the seller is not truly 'short'. This is based on the argument that the seller, relying on the agreement to borrow stock, has a 'presently exercisable and unconditional right to vest the product' at the time of sale. As a result of this, there is currently very little regulation relating to covered short sale transactions involving Australian securities. As a result of this, there is currently no disclosure applicable to these transactions. This makes it difficult to determine the amount of covered short sale activity taking place in Australian securities. However, it is believed that covered short sales are more common than naked short sales. An estimate of the amount of covered short selling activity can be derived from measures of the total value of securities available for lending. The Reserve Bank of Australia has reported that the value of equities loans outstanding was around $60 billion at the end of 2007.

5.5 It should be noted that some borrowed securities are used for purposes other than short selling (for example, parties may enter into a securities lending agreement to facilitate an arbitrage transaction relating to the security or to cover potential settlement failures), so this figure overstates the amount of covered short sale activity. It is impossible to determine exactly the proportion of stock lending transactions that are used for covered short sales. For this reason, stakeholders, including the ASX, have questioned whether stock lending data can be used as a reliable proxy for the amount of covered short sales.

5.6 Based on the data above, it is estimated that the upper limit of short selling activity in Australian securities is approximately $60 billion. This equates to approximately 4 per cent of the total capitalisation of Australian listed securities (based on a total ASX market capitalisation of $1.5 trillion). The majority of this is expected to be in the form of covered short sales. The current uncertainty surrounding the actual level of short selling activity in Australian securities is compounding the direct impact of this activity as it is resulting in rumour and speculation in the marketplace.

Issue

5.7 The current degree of uncertainty surrounding the activity of covered short sellers in Australian securities is having a significant impact on Australian capital markets. Currently, when a security experiences a significant decline in price, it is unclear whether this is attributed to short selling activity or other factors, which is resulting in considerable rumour and speculation regarding short selling activity and potentially adding to price volatility. Speculation regarding the level of short selling activity in Australian securities is also having broader market implications. Confidence in the market, particularly among retail investors, is likely to be damaged as investors express concern about the perceived activity of short sellers in the market. A fall in market activity, and investor confidence about the integrity of Australian capital markets, will make it more difficult for companies to raise additional capital leading to an increase in the companies overall cost of capital and a fall in investment activity.

Objectives

5.8 The objective of Government action in this area is to increase transparency surrounding the activity of covered short sellers in Australian securities. This would provide useful information to investors and regulators and also contribute to confidence and market integrity. In particular, disclosure of covered short selling activity:

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will provide an early signal that individual securities may be overvalued;

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will indicate that a proportion of the sales in an individual security will need to be reversed by new purchases (to cover the short seller's settlement obligations);

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will enhance investors' willingness to participate in the market by removing uncertainty surrounding the level of short selling; and

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may deter market abuse or reduce the opportunities for market abuse.

5.9 The Government is not seeking to prohibit or discourage covered short selling activity. It is recognised that covered short selling activity, appropriately regulated, is beneficial to the operation of capital markets by increasing market liquidity and pricing efficiency.

Implementation options

Option one: Retain the status quo (no regulatory action)

5.10 This involves retaining the current regulatory arrangements and seeking to encourage voluntary disclosure of covered short sales.

Option two: Disclosure of covered short sales to brokers

5.11 This involves placing an obligation on investors to disclose covered short sale transactions to their broker. The broker will then be responsible for reporting this information to the relevant entity, for example, the market operator.

5.12 Under this option, the general disclosure requirement and the penalties for failing to disclose information would be contained in the Corporations Act. However, supplementary regulations would be used to outline the technical aspects of the requirement including the timing of any disclosure and whether the investor is required to disclose transactions on a gross or net basis (gross disclosure would encompass any covered short sale transaction entered into by the investor whereas net disclosure would take into account any offsetting transactions entered into by the investor so only their net exposure was disclosed). Specifying the technical aspects of the disclosure requirement in regulations provides sufficient flexibility so the requirements can be amended to take account of any changes in market activity in the future. Given the ongoing and rapid development in the conduct and structure of financial markets, the regulations may also allow for the disclosure regime to be targeted to particular areas in the future.

Option three: Direct disclosure of covered short sales to the market operator

5.13 This involves placing a direct obligation on investors to disclose covered short sale transactions to the market operator. As discussed under option two, this requirement would be implemented through the Corporations Act supported by supplementary regulations covering the technical aspects of the disclosure requirement.

Option four: Disclosure of stock lending transactions

5.14 This involves requiring disclosure of all stock lending transactions on the grounds that it is a sufficient proxy for the level of covered short selling activity in a particular security. Similar to options two and three above, this option could be implemented through the Corporations Act supported by supplementary regulations.

Option five: Review existing short selling regime

5.15 This involves a wholesale review of the regulatory framework governing all short selling transactions (both naked and covered). This review would cover the existing rules relating to short sales in the Corporations Act.

Assessment of impacts

Option one: Retain the status quo (no regulatory action)

5.16 This option has the benefit of imposing no additional regulatory costs on businesses. However, it will not address the current issues caused by the uncertainty in the market place regarding the level of covered short selling activity. There is no incentive for investors to disclose this information to the market. In addition, there is little capacity for the Government to encourage investors to voluntarily disclose this information particularly in circumstances where short selling activity is being driven by foreign investors. This means that without some level of Government intervention in the market, this information is unlikely to be disclosed.

Option two: Direct disclosure of covered short sales to brokers

5.17 This option has the benefit of ensuring the market is fully informed regarding the actual level of covered short selling activity. As discussed above, the removal of the current level of uncertainty surrounding short selling activity will benefit the market by promoting greater market confidence, increasing the information available to investors and assisting regulators to identify potential market abuse.

5.18 Targeted consultation with stakeholders has indicated that the implementation of this option is likely to impose costs on market participants, particularly the market operator (ASX) and brokers. The ASX will need to amend its trading system for Australian securities to facilitate the reporting of covered short sales by brokers. This will also require the systems used by brokers to process sales transactions to change so that it is in line with the ASX trading system. In addition, they may be required to amend other trading systems they offer investors for example direct market access systems. This will be particularly relevant for those brokers that are not currently reporting naked short sales to the ASX. The extent of these costs and the proportion of brokers that will offer their clients the ability to execute covered short sales are currently unknown. The extent of any changes to systems is only likely to be known once the precise details of the disclosure regime are settled through any supplementary regulations.

5.19 For investors, the cost of reporting covered short sale transactions to their broker will depend on the size and complexity of their operations. For individual investors, the costs should be relatively minimal. However, for larger companies, particularly those with multiple trading desks, the costs could be significant. This is because different trading desks within the company may be taking different positions in the same security at the same point in time. The potential for simultaneous trading activity in the same security by different parts of the company makes it difficult for companies to know whether they are long or short a particular security on a real time basis. This situation can be further complicated when the company acts as both a broker and an investor (for example, an investment bank). Stakeholders have indicated that these costs become less significant in situations where reporting of covered short sale transactions is delayed. The timing of any disclosure requirement under this option would be determined through the supplementary regulations.

5.20 In addition, some investors have expressed concerns surrounding the potential loss of confidentiality regarding their trading activities. It is intended that the disclosure regime would only result in the reporting of aggregated data, so individual trades cannot be identified. However, there may be indirect information leakage when the investor reports the trade to their broker (for example, by the broker disclosing this information to other investors). The potential costs associated with any loss of confidentiality will be influenced by the timing of the disclosure. For example, if disclosure is required at settlement rather than when the order is executed, the costs associated with the loss of confidentiality is reduced. However, the information will be less useful to investors if only delayed disclosure is required. Decisions regarding the timeliness of reporting obligations will be settled through any supplementary regulations.

Option three: Direct disclosure of covered short sales to the market operator

5.21 As this option also results in the full disclosure of covered short sales, it will have the same benefits as option two outlined above. The primary difference between this option and option two relates to the incursion of regulatory costs.

5.22 Relative to option two, this option imposes less of a regulatory burden on brokers. This is because investors will no longer be required to report covered short sales to their broker. However, it is expected that it would impose a significantly greater regulatory burden on the market operator and investors. In relation to the market operator, it is expected that the implementation costs would be significantly greater if they receive the information directly from investors rather than through brokers as proposed under option two. This is because the market operator will need to establish processes and systems for this reporting of information directly from investors. In contrast, under option two, the market operator would be able to take advantage of processes and systems already in place for the reporting of information between brokers and the market operator.

5.23 Investors will also be required to make significant changes to their processes and systems to facilitate the reporting of this information directly to the market operator. These would be in addition to the costs for investors identified under option two in relation to determining their exposure on particular securities. However, a relative advantage of this option over option two for investors relates to confidentiality. In particular, by requiring this information to be reported directly to the market operator (rather than through a broker), there is a significantly reduced chance of information leakage regarding individual trades. As discussed under option two, the costs to investors associated with this loss of confidentiality will be largely influenced by the timing requirements placed on disclosure which will be determined through any supplementary regulations.

5.24 It is expected that the additional costs incurred by investors and the market operator under this option will be greater than the costs incurred by brokers under option two. This is because there are a smaller number of brokers (relative to investors) and the extent of change necessary to the systems will be less as brokers are already required to report information of a similar nature to market operators.

Option four: Disclosure of stock lending transactions

5.25 The benefit of requiring the disclosure of stock lending transactions is that it would provide information to the market that could act as a proxy for the level of short selling activity in Australian securities. However, as noted above, some stakeholders have questioned whether stock lending data will provide a sufficient indication of short selling activity given stock lending transactions are used for a range of other purposes in addition to short selling. Given this, disclosure of stock lending alone is unlikely to fully address the uncertainty in the market relating to the activities of short sellers.

5.26 The implementation of a stock lending regime will involve some regulatory costs for investors that would be required to report these transactions. In particular, the Government understands that IT infrastructure changes would almost certainly be needed to facilitate the reporting of this information to the securities settlement systems. Industry has informed the Government that the costs of making these changes will be influenced by the service agreements individual participants have with vendors. However, the total regulatory cost of implementing these changes is likely to be less than the regulatory costs associated with options two and three.

Option five: Review existing short selling regime

5.27 It has been a number of years since there was a comprehensive review of the short selling regime in the Corporations Act. A review of the existing regime would assist in ensuring the regulatory requirements reflect current market conditions and trading behaviour. While a review of the existing short sale review may be useful in the long term, it will not assist in resolving any of the uncertainty surrounding short sales in the near term. In addition, implementing a disclosure regime for covered short sales prior to the commencement of a more general review of regulatory arrangements would allow the information resulting from the disclosure regime to inform the review and lead to a more effective regulatory outcome.

Consultation

5.28 To date, the Government has engaged in targeted consultation with stakeholder groups regarding the disclosure of short sales. Discussions at this meeting focused on identifying current market practice, the scope for additional disclosure of covered short sales and the likely impact on industry of any regulatory change. This includes meetings with ASIC, the Association of Superannuation Funds of Australia, Australasian Investor Relations Associations, Securities and Derivatives Industry Association, Australian Shareholders' Association, Australian Securities Lending Association, Australian Financial Markets Association, Investment and Financial Services Association, the Alternative Investment Management Association and the ASX. These meetings were high level in nature and did not seek specific comments from stakeholders on each of the options identified above. However, the feedback from these meetings, in particular as it relates to possible implementation costs for investors and brokers, has been drawn on to develop the impact analysis section of this paper.

5.29 In addition, the ASX issued a consultation paper on short selling in April 2008. The Government considered the submissions received by the ASX on this paper as part of developing and considering its options for reform in this area. Submissions were received from a broad range of stakeholders including institutional investors, brokers, investment banks and investor associations. The ASX has not made these submissions publicly available.

5.30 The Government will also engage in public consultation by exposing draft legislation for public comment of any regulatory option adopted. This will ensure the views of the wider public are taken into account on this issue.

Conclusion and recommended option

5.31 This document outlines a range of possible policy options relating to the regulation of covered short sale transactions. Options considered include:

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no regulatory response;

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disclosure of covered short sales by investors to brokers;

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direct disclosure of covered short sales by investors to the market operator;

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disclosure of stock lending transactions; and

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review of the existing short sales regime.

5.32 Based on the impact analysis outlined above, option two has been selected as the recommended approach. Under this option, investors that enter into covered short sale agreements will be required to disclose this transaction to their broker. Technical aspects of the disclosure requirement, for example the timing of disclosure and whether disclosure of transactions is on a net or gross basis, will be specified through supplementary regulations (still to be issued).

5.33 Implementation of option two will result in the actual level of covered short selling in a particular security being disclosed to the market. This will provide confidence to investors and also facilitate the identification of market abuse by regulators. However, it is recognised that this option will involve some regulatory costs, particularly by brokers and large investors that are required to update their existing systems to facilitate reporting of covered short sale transactions. While the precise amount of these costs cannot be determined until the technical aspects of the disclosure requirement is settled, it is expected that the regulatory costs associated with this option is less than what would result from the adoption of option three. The remaining options fail to sufficiently address the identified issue because they would still result in uncertainty surrounding the actual level of short selling activity in Australian securities.

Implementation and review

5.34 The Government is conscious of the need to effectively engage with industry to ensure the preferred approach is implemented in a way that minimises regulatory costs. The first stage in this process will be to consult with industry on the technical aspects of the disclosure requirement as part of developing the supplementary regulations. By specifying these issues by way of supplementary regulation, the regime will have sufficient flexibility to adjust to changes in trading behaviour of investors in the future and the conduct and structures of financial markets. Following this, a transitional period is likely to be offered to allow brokers sufficient time to make the necessary changes to their IT infrastructure in order to enable reporting of these transactions.

5.35 As the regime will be implemented through the Corporations Act, ASIC will be responsible for monitoring compliance behaviour of investors and brokers and taking enforcement action where appropriate. The Government will also continue to monitor the application of the regime to ensure that it is operating effectively. The Government intends to formally review the measures once they have been in operation for two years.