A new paper by Marco Dell’Erba and Giovanni Patti takes a look at a recent crisis involving the stock of the Monte dei Paschi di Siena (MPS), as a way of studying the pragmatics of the European Regulation on short selling (SSR).
Dell’Urba is affiliated with the New York University School of Law and is a postdoctoral fellow at the University of Groningen, in the Netherlands. Patti identifies himself as an independent scholar. Their article, “The Monte dei Paschi Affair: Distressed Banks and the European Regulation on Short Selling” has appeared in the Capital Markets Law Journal and in late April 2018 became available to the public via SSRN.
Facts and Acronyms
The MPS, one of the world’s oldest banks, entered crisis in 2015 (trading in its shares was briefly suspended that July) due to what Dell’Urba and Patti call summarily “bad management decisions and illegal activities.” Its instability “spurred speculative ideas among hedge funds in search for troubled assets.” These authors take for granted the general idea that national and international authorities have to be able to intervene in the case of a crisis to limit short selling even where (as they acknowledge is generally the case) the short selling is not the origin of the problems but serves what they call a transmissive function (moving risk around).
Specifically, the SSR provides that in exceptional circumstances, especially involving a significant fall in price of assets, the European Securities and Market Authority (ESMA) and the national competent authorities (NCAs) working under its umbrella, have to be able to halt the drop somewhere above zero.
In Italy, the NCA is the Commissione Nazionale per le Società e la Borsa (CONSOB).
CONSOB acted to stop short selling in MPS. In the words of Dell’Urba and Patti, this was done not solely to safeguard the restructuring process of the bank but to safeguard “the stability of the overall Italian banking sector.”
In January 2016, some of the hedge funds active in this institutional space were buying up MPS’ non-performing loans at the lowest possible price. By shorting MPS shares, they could put downward pressure in the equity price, and this could put them in a stronger negotiating position for the purchase of those loans. A lower price in the one could help the hedge funds obtain a lower price for the other. That, at least, is the claim that caused CONSOB to ban further short sales.
An Unfortunate Loophole
Dell’Erba and Patti see it as an unfortunate loophole that, even after the enactment of this ban, the hedge funds were able to continue to exert bearish pressure on the equity price by buying put options from the market makers.
Why were they able to buy these put options? Because market makers were free to sell them the options.
Yes, you might say, but shouldn’t the market makers have worried about their own exposure? They were going long on MPS by selling the options. That was a highly speculative thing to do. Didn’t the short sale ban keep them from hedging that long position? And might the impossibility of hedging have deterred them from selling puts, closing this loophole before it even had a chance to open?
Well … no. The market makers were allowed to short sell. The SSR exempts market makers, at least insofar as they are acting pursuant to their market making role, from such a ban. This exemption implements a principle announced by IOSCO in 2009 and it is consistent with views expressed by both the IMF and the ECB.
That requires reconsideration ahead of future crises, say these authors. They write: “[I]f investors force the market maker who sold the put options to hedge its short put position by heavily short selling the stock, then the depressing effect on the price of the stock would allow the investor to profit by utilizing the short position taken by means of the put option.”
As to timing, it is usually the case that the depressing consequence on equity prices through this indirect channel takes more time than does the depressing consequence of direct short sales by the hedge funds and other market speculators. But the MPS case shows that, in some special cases at the least, the depressing effect of short selling is “more immediate” when it is coming from the market makers than otherwise.
In their conclusion, Dell-Erba and Patti take the view, then, that ESMA and the NCAs should change their rules, and allow themselves in future crises to “prohibit market makers to use the exemption in the context of a transaction that would let investors increase their net short positions in the focal stock.”