Short Positions: what it is and how it is regulated

Index:

• What are short positions?
• How to go short on an asset?
• How are short positions regulated?
• Advantages and disadvantages

What are short positions?

A short position is one in which market value of underlying asset is expected to fall, thereby making a profit. The simplest way to take a short position on an asset is to start with a loan. You sell an asset that you don’t have, then buy it at a lower price and refund the loan. In this exchange, a profit is made if the price of the asset falls. In addition to this method, it is possible to short through Contracts for Difference (CFDs) and derivatives.

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European passport for ESISs, IICS and SGIICs

The European Passport is talking about authorization to market certain financial products within the territory of the EU. In addition, it is necessary to differentiate the type of financial product to be commercialized. The process for obtaining the authorization / European Passport is different depending on the case. Thus, it is necessary to speak separately of authorization for ESIs, IICs and SGIICs.

How to go short on an asset?

Let’s describe the most common process of shorting a security.  First, you borrow shares of the underlying on which you want to take a short position. In return for this loan, the investor who wants to short pays a price. For example, two euros. The investor agrees to return these shares to the owner on a specified date.

Once he has possession of the shares, the investor sells them to another investor seeking to go long. He sells them, for example, for 25 euros. But since our bearish investor must return them to the owner, he must buy new shares to fulfil his obligation. Our investor buys those shares at 20 euros.

Once he buys the shares, the investor can return them to the lender, thus completing the transaction. In this operation, as the value of the asset has fallen, our investor has made a profit. The concrete profit in this case would be 25 – 20 – 2 = 3 euros.

How are short positions regulated?

In view of the financial crisis in 2008, many market supervisors decided to restrict or directly prohibit short positions. They feared that short positions would bankrupt companies whose share price was plummeting. These drastic measures by supervisors alerted regulators to the need for rules in this area.

Thus, short positions were regulated at European level through Regulation EU 236/2012. This Regulation contains directly applicable measures for Member States on short selling. Analyzing its content, there are two main consequences it has on short positions:

• On the first one, the Regulation imposes greater transparency with respect to significant short positions. Thus, it imposes two methods of transparency: private notification and publication according to the percentage of capital.

In this way, the Regulation obliges investors to notify the competent authority when:

• They have short positions of 0.2% or more of a company’s issued share capital.
• Once this threshold is exceeded, they must notify each 0.1% segment.

With regard to publication, the Regulation requires investors to publish that:

• Have short positions on 0.5% or more of a company’s issued share capital.
• Above this threshold, they must publish each 0.1% segment
• In addition, the Regulation empowers competent authorities to restrict or prohibit short positions under certain circumstances. Articles 18 et seq. of the Regulation allow for this. These measures may be maintained for a maximum of 3 months, with possibility of extension for a further 3 months. The notice shall specify the measures imposed and the reasons for them.

Advantages and Disadvantages

As far as the advantages that short positions have over the market can be summarized in three:

• They give liquidity to the market. As we have seen, trading with short positions involves a sale and a purchase by the investor. This multiplies the number of transactions on an asset, which increases the chances of finding a counterparty to a transaction. Thus making the market more liquid.
• They help the efficiency of the markets. As is logical, the more operations there are on the same asset, the closer its price will be to its real value.
• Short positions do not always have a speculative purpose. They can be used to hedge a long investment in the same asset.

There are also two main disadvantages to short positions:

• They are used for speculative purposes. While not their only purpose, short positions are often used to drive down a security. Think of the consequences of a major investor’s short position on the price of a security.
• They put pressure on employers to make decisions. If short positions in the shares of a company, entrepreneurs, fearing a collapse of the share price, will modify their decisions to prevent it.

Conclusions

Short positions are one of the most controversial trades that can be made in the market. Many are its detractors, arguing that its speculative purpose justifies its permanent prohibition. But further analysis leads to the conclusion that short positions can be beneficial to the market. Especially when there is the possibility of restricting their use in periods of crisis, when they can be harmful.

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Securities lending and repurchase transactions