EUROPEAN SECURITIES AND MARKETS AUTHORITY (ESMA) CONSULTATION PAPER

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1 EUROPEAN SECURITIES AND MARKETS AUTHORITY (ESMA) CONSULTATION PAPER 22 City Road Finsbury Square London EC1Y 2AJ Tel: +44 (0) Fax: +44 (0) DRAFT TECHNICAL STANDARDS ON THE REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL ON SHORT SELLING AND CERTAIN ASPECTS OF CREDIT DEFAULT SWAPS RESPONSE FROM THE ASSOCIATION OF PRIVATE CLIENT INVESTMENT MANAGERS AND STOCKBROKERS (APCIMS) 1 Introduction APCIMS welcomes the opportunity to respond to ESMA s Consultation Paper on Technical Standards for the Regulation of Short Selling. The APCIMS grouping comprises intermediaries serving the retail investment community in a variety of ways. These include the provision of on-exchange dealing for retail clients in shares and other listed products, including ETFs and bonds. It is almost certain that any retail person trading on-exchange in the UK will do so through a broker who is an APCIMS member. There are around 25 million such retail trades annually in the UK so the quantity of dealing is not insignificant. Neither is the average bargain size, which at some 20,000 compares well with the average wholesale bargain under conditions of High Frequency Trading (which does not operate in the UK retail sector). In view of this background we believe that it will be important for ESMA in its work on definitions to take careful account of the retail aspect of the market and how it will be affected by the outcome. APCIMS had concerns in particular about Article 12 of the Short Selling Regulation while it was under negotiation between the Commission, Parliament and Council and our responses below to the ESMA paper are limited to questions related to Article 12. We prepared a short note on this at the time, a copy of which is attached at Annex I. 1 The Association of Private Client Investment Managers and Stockbrokers (APCIMS) is a trade association representing 170 member firms. Of this number 116 members are private client investment managers and stock brokers and 54 are associate members who provide related services to our firms. Member firms deal primarily in stocks and shares as well as other financial instruments for individuals, trusts and charities and offer a range of services from execution only trading (no advice) through to full portfolio management. Our member firms operate on more than 500 sites in the UK, Ireland, Isle of Man and Channel Islands, employing c employees. Over 475 billion of the country s wealth is under the management of our members. Our aim is to ensure that regulatory, tax and other changes across Europe are appropriate and proportionate for the investment community. Association of Private Client Investment Managers and Stockbrokers Company limited by guarantee Registered in England and Wales No VAT Registration No

2 The note draws the distinction between agency and proprietary or principal trading and refers to the role of the retail service provider (RSP) or market maker in actually sourcing the shares for agency brokers and executing the on-exchange deals for them. The RSP then provides the broker with the shares for onward sale to the eventual retail investor. Article 12 may be drafted mainly with proprietary trading in mind, but APCIMS firms are agency brokers dealing in shares on behalf of retail clients and not on their own account. They do not, and indeed are not allowed to, engage with client money in the sort of deliberate, possibly uncovered or naked, short selling strategies that a proprietary trader might undertake and that Article 12 seeks to address. But under certain circumstances they may through no fault of their own be unable to deliver stock to a client by a due date because the stock they have bought for onward sale has not been delivered to them by the RSP. They may then appear to be in a naked short sell situation even though this was not intentional. The response to Question 5 below and Annex I give further details. We wish to ensure that the interpretation of Article 12, particularly of the phrase to have reasonable expectation that settlement can be effected when it is due, takes account of this accidental naked short sell situation by retail agency brokers and goes as far as possible towards providing safe harbour for them on the occasions when they cannot deliver to a client because of third party difficulty. Q1: Do you agree with the approach of providing an exhaustive list of types of agreement, arrangement and measure that adequately ensure shares or sovereign debt instruments will be available for settlement and setting out the criteria these should fulfil? No exhaustive list can stay exhaustive forever in view of the effects of innovation and change in the markets. They are not and will not be static so lists of the kind proposed are bound to change and become out of date. It follows that to make the list exhaustive a final catch-all category should be added along the lines of: Any other agreement, arrangement or measure not described above that ensures in accordance with the criteria laid down that shares will be available for settlement. Q2: Do you agree with the proposed list of agreements and enforceable claims and the criteria they should meet? Are there any other types of agreement or enforceable claims or criteria which should be added? Yes. Q3: Do you consider that these criteria will entail additional costs as compared to current practices on the market? If so, could you specify the drivers for those additional costs and any indication of their amount? No. Q4: Do you agree with the proposed list of third parties which may be parties to the arrangements or measures and the criteria proposed by ESMA that they should fulfil? Yes, subject to the answer to Question 5 below. Q5: Are there further criteria which should be added? 2

3 Yes: a Retail Service Provider (RSP). The RSPs in the UK provide a retail market making service to investment firms or agency brokers acting for retail clients. A short paper on the RSPs is attached at Annex II. Trades through an RSP are reported to a Regulated Market usually the London Stock Exchange as on exchange trades. Investors therefore receive the full protection of exchange rules to ensure, inter alia, prompt settlement and protection from counterparty default. In the example given in the Introduction on how a retail agency broker might typically fall into an accidental naked short selling situation, it is from the RSP that the firm would obtain the shares for onward sale to the ultimate client. If the shares are in exceptional demand by the retail sector there may be none for sale and although a retail client may demand under execution only rules an immediate purchase, which the agency broker will put to an RSP, the RSP may simply be unable to get hold of the shares in time for the firm to sell to the ultimate client by the due date. This would be the accidental naked short which should fall into the safe harbour provided by Article 12. The RSP as a market maker falls under the market maker exemption but the investment firm or agency broker should be defined as having the reasonable expectation of obtaining the shares from the third party, or RSP, and so be covered by Article 12(3) in the event that the RSP cannot obtain them in time, despite having promised to do so. The RSP model is a quote driven system that facilitates an appropriate environment for retail trading separately from the order driven wholesale trading environment available in the UK. The effect of this structural separation is to isolate retail business from wholesale in the sense that activities undertaken specifically in the order driven wholesale market, such as algorithmic or HF trading, do not directly impact on retail business. Q6: Does the fact that a third party should be a distinct legal entity from the entity entering into the short sale entail costs? If so please provide estimates of those costs. No additional costs other than those already being paid. Q7: Do you agree with the approach proposed by ESMA on the standard/same day/liquid shares locate confirmation arrangements and measures and the criteria that they must fulfil? Yes, provided the third party definitions from whom the investment firm or agency broker is to obtain the shares include the RSP. Q8: In circumstances other than intraday short selling or short selling on liquid shares, can you suggest any additions to the methods for effective allocation set out in this consultation paper which would provide the necessary comfort that shares can be delivered for settlement in due time? Yes: the allocation method used by the RSPs to make sure that in all cases except the most exceptional the retail investor is supplied on time with the shares to be bought on his behalf and sold to him. See Question 5 and the Introduction for a more detailed description of where this could fail and the accidental naked short, for which safe harbour under Article 12 should be available, might occur. Q9: In relation to the approach suggested for liquid shares, do you consider it appropriate to use the MiFID definition of liquid shares? Do you think ESMA should consider different approaches to determine the reasonable expectation test for liquid and illiquid shares? If not, can you provide indications as to the criteria to 3

4 consider to define liquid shares or to take into account the liquidity of the shares in these circumstances? Is securities lending activity an additional factor to consider when determining liquidity of a share? We agree that the MiFID definitions of liquid shares should be used as a criterion for determining that a reasonable expectation has been met. However, in the case of an illiquid share which a retail client has asked an agency broker to buy, the reasonable expectation test must be that the broker can reasonably assume that the RSP who offers to undertake the deal can obtain the shares. The RSP then becomes the party responsible for providing the shares in time for settlement date. Any failure to do so will be subject to the rules and penalties of the exchange to which the transactions are reported. The RSP as a market maker would need to claim the market maker exemption under the Regulation. Q10 Q20: No comment. APCIMS, 13 February

5 ANNEX I EUROPEAN PARLIAMENT SHORT SELLING REGULATION: NOTE FROM APCIMS ON ARTICLE 12 It is critical to understand that an accidentally failed delivery of stock that leaves a retail agency broker not meeting an intended settlement date because he has not yet got the shares is not a naked short sell. This event can and does take place in the retail sector and needs to be taken into account in drafting the Regulation and its interpretations. There are legal distinctions between member states on how settlement is approached. In some member states the intended settlement date does not provide a legal guarantee of settlement at that time and it is not a criminal offence to miss it, although it may be an offence against the rules of an exchange. In other states however the guaranteed settlement date is a legal requirement which must be met. The Regulation needs to be drafted in a way that can accommodate both these situations. APCIMS members are retail agency brokers buying and selling shares and other financial products on behalf of retail clients in discretionary managed portfolios, or providing executiononly broking services to retail clients wishing to undertake on-exchange trading, or providing purely advisory services. They do not undertake proprietary dealing or dealing as principal and do not undertake deliberate short strategies with other people s money. The firms utilise Retail Service Providers (RSPs), which are essentially retail market makers, to access the best execution venues for their clients and the RSPs actually execute the on-exchange deals. This mechanism requires the agency brokers to strike an agreement with the RSP for delivery of the stock which they are buying for the ultimate retail client, and the RSP is then responsible for obtaining it. Usually the RSP then delivers the stock to the agency broker who settles in due time by onward delivery to the retail investor who originally requested the deal. But there may be a situation with, for example, a rapidly rising stock which retail investors are buying and which the RSP cannot immediately get hold of because he finds that nobody is selling. In these situations the agency broker may not be able to receive the stock from the RSP and deliver it to the client until a few days after settlement date because their market counterparty, the RSP or market maker, is unable to deliver it in time. The broker would then appear to be in a naked short sale but in fact is not. They might also be caught if for example they have taken out an options hedge in a discretionary managed client portfolio and need to exercise a put at some point. If they do not have the stock at that time they could at the end of the day be without cover and it would be important for Article 12 safe harbours to shield them against accusations of failing to deliver because of naked short selling. The recent drafts of Article 12 allow the reasonable expectation test that settlement can be effected when it is due in the context of a firm having an arrangement with a third party to locate the shares for sale. In these circumstances if a broker went through a market maker (RSP) to locate the shares but failed to receive the shares in time for an intended settlement, the broker should be able to claim reasonable expectation that the RSP would get them and the RSP would be covered by the market maker exemption. APCIMS, July

6 ANNEX II THE RETAIL SERVICE PROVIDER (RSP) MODEL Description of the RSP model The RSP forms the backbone of the UK retail stock broking market, its primary role being to provide electronic quotation and dealing facilities to retail stockbrokers and other investment firms. In practice a stockbroker will electronically connect to a number of competing RSP firms, requesting the RSPs most competitive quote for their client s order. The brokers will select the most competitive price offered allowing their clients to benefit from price competition between RSPs and to deliver best execution to their clients. One key element of the model is the price calculation mechanism employed by the RSP systems. Market Makers invest significant capital in the development of technology to allow the most competitive prices to be formulated and hence the most order flows to be won. RSP systems consolidate price data from the market data feeds of the regulated markets and MTFs (the Exchanges ) in order to build a consolidated best bid/offer across those venues. The RSPs investment in consolidation therefore provides significant benefits for the retail investor while reducing the risks associated and successfully delivering best execution. Some key benefits of the RSP model are detailed below: Self Determination o The RSP model allows retail clients to access and interact with markets at their own discretion. The UK retail client has benefitted from the development of the RSP system which has significantly reduced the cost of trading and opened up equity trading to a wider audience. o This deeper pool of capital has assisted listed companies, particularly those admitted to small cap markets such as Aim and Plus Markets, to weather the financial crisis. These markets have provided access to much needed funding to create economic growth and jobs while offering returns to investors. This has been of critical importance given the widespread contraction in bank lending since the economic crisis and the smaller returns available to savers. Reduction in the cost of trading o Single execution means no clearing fees and a single settlement 2. Protects the investor o While executed away from the exchange systems, trades are reported to an Exchange as on exchange trades. Investors therefore receive the full protection of exchange rules to ensure, inter alia, prompt settlement and protection from counterparty default. Pre-trade transparency 2 Cost is a key factor in obtaining best execution of a Retail Client order. 6

7 o Registered market makers are required to make firm quotes in minimum sizes determined by an Exchange throughout the trading day. The RSP references these prices and hence cannot be considered a Dark Pool. o Investors are shown the full terms of trade (price, quantity, settlement date) prior to committing to the trade. This allows client certainty that their trade has executed at a known price. This is not possible through other execution methods and offers the best element of a limit order (price certainty) and an At Best order (immediacy). o Prices provided by RSPs represent the tightest spreads available in a security by referencing multiple order books/market maker quotes in order to match the markets best price. 3 Highly competitive o Up to 30 market makers may be competing for each order. In order to win the client s order the market maker will apply price improvement to enhance further the price offered to the client. o Under the RSP model the market maker does not charge for access to RSP prices and no commissions are paid to RSPs for execution. Highly efficient o RSPs run highly automated systems: a very high percentage of all executions are processed and settled on a straight through processing (STP) basis which significantly improves the likelihood of settlement. 4 o STP also significantly reduces the operational costs of the RSP and broker, thus allowing low dealing costs and a very competitive broker market; best execution for retail clients should be considered against the full cost of a trade rather than just its price and the RSP model significantly improves this area to the benefit of the retail client. o The RSPs price consolidation allows a single point for clients to access the prices available across numerous venues. o Electronic trading via the internet allows investors instant access to the market; thus investors can easily take advantage of the market situation or dispose of existing positions. 5 o Guaranteed execution: once a quote is received by the client, the price is held firm to allow the client to decide. 6 Highly Liquid 3 Price is a key factor in obtaining best execution of a Retail Client order. 4 Likelihood of settlement is a key factor for the best execution of a Retail Client order. 5 Speed is a key factor in obtaining best execution of a Retail Client order. 6 Likelihood of execution is a key factor for the best execution of a Retail Client order. 7

8 o In addition to price improvement, market makers will offer liquidity improvement, providing more liquidity at current market prices than are available on the regulated market and MTF order books. 7 As the above description makes clear, the UK s retail execution model for equity business is a well developed, competitive system that is highly efficient and delivers significant benefits to its end client, the retail investor. The service delivers against all of the execution factors determined by the Markets in Financial Instruments Directive ( MiFID ) as the footnote references demonstrate. The model is highly effective and offers many advantages over the retail execution models prevalent in other markets, including those found elsewhere in the EU. 7 Likelihood of execution is a key factor for the best execution of a Retail Client order. 8