My Lords, this statutory instrument forms part of the work being delivered to ensure that there continues to be a functioning legislative and regulatory regime for financial services in a scenario where the UK leaves the EU without a deal or an implementation period. As a responsible Government we are of course preparing for all potential scenarios, despite remaining confident of securing an ambitious deal with the EU.
The instrument has been drafted using powers delegated to Ministers under the European Union (Withdrawal) Act 2018 to address deficiencies in applicable EU law relating to the regulation of short selling that will be transferred directly on to the UK statute book at the point of exit. It will also amend relevant parts of the Financial Services and Markets Act 2000. This is in order to provide continuity, given that the approach of the European Union (Withdrawal) Act is to maintain existing legislation at the point of exit. The instrument has already been debated in the House of Commons this morning.
Short selling is the practice of selling a security that the seller has borrowed, with the aim of buying the security back at a lower price than the price that the seller sold it for. The short selling regulation, the SSR, was introduced after the financial crisis to enable the EU to act to suspend or ban short selling in cases where financial stability was at risk. It covers the EU’s regulatory oversight of short selling and certain aspects of credit default swaps, and relates to financial instruments that are admitted to trading or traded on an EEA trading venue.
Post exit, the SSR will no longer be effective in maintaining the framework to regulate short selling and certain aspects of credit default swaps in the UK. This is because in a no-deal scenario the UK will be outside the European Economic Area and therefore outside the EU’s regulatory, supervisory and legal framework. The solution is therefore this instrument, which will amend the retained EU law related to SSR to ensure that it continues to function effectively in the UK post exit.
The instrument makes the following amendments. First, it will amend the scope of the regulation to ensure that it captures instruments admitted to trading on UK venues and UK sovereign debt only. The SI will therefore not capture instruments admitted to trading only on EEA trading venues. Furthermore, amendments have been made under the instrument that change the scope of the UK’s powers to address threats to stability or market confidence in the context of the regulation. Currently the SSR allows the UK to act against instruments that have their most liquid market in the UK or if the instrument was first admitted to trading in the UK. That has the effect of requiring the UK to seek consent from the relevant EU regulator if it wants to take action on the basis of an instrument that has its most liquid market elsewhere in the EU or was first admitted to trading on an EU venue. The instrument removes that provision. In line with other third-country instruments, the UK will in future be able to take action against any instrument traded on a UK venue. The UK will be required to consider threats to UK market confidence and financial stability only before using these powers.
Secondly, the instrument transfers functions currently carried out by EU authorities to the appropriate UK bodies. For example, powers will be transferred from EU supervisory bodies to the FCA as the most appropriate regulator, given its expertise in regulating short selling currently. These include the power to make technical standards: for example, to take action on all instruments admitted to trading on a UK venue, not just those for which the UK is the most liquid market. Functions are also transferred from the European Commission to the Treasury, as in other statutory instruments, including the power to specify when a sovereign credit swap transaction is considered as hedging against a default risk.
Thirdly, the instrument will maintain a number of existing exemptions. Certain exemptions are already provided for reporting requirements, the buy-in regime and restrictions on uncovered short selling for shares that are principally traded in a third country. These will be retained. In respect of the last point, the FCA will take on the responsibility for publishing the list of relevant third-country shares. This ensures continuity by recognising the European Securities and Markets Authority’s list for two years following exit day. Additionally, the instrument will maintain the SSR’s exemption for market makers and authorised primary dealers. Market makers will be required to join a UK trading venue and notify the FCA at least 30 days before exit should they want to benefit from this exemption. Those who have done so already will not see any change. The exemption means that firms can carry out certain market-making activities and primary market operations without disclosing their net short position, and they are not required to comply with restrictions on uncovered short selling, provided that they meet certain thresholds.
Additionally, amendments provide HM Treasury with the power to set relevant thresholds after exit. The instrument will also allow market participants to use UK credit default swaps to hedge correlated assets and liabilities elsewhere in the world rather than just the EU. This will ensure that UK firms can continue to use UK sovereign credit default swaps to hedge correlated assets or liabilities issued by issuers outside the UK.
Lastly, the instrument deletes provisions that facilitate co-operation and co-ordination across the Union. Currently member states must notify other regulators ahead of taking action to restrict short selling, with other regulators then determining whether to apply corresponding restrictions. This SI deletes these provisions, as well as deleting the European Securities and Markets Authority’s intervention powers except in exceptional circumstances.
The SI makes technical amendments to existing UK legislation—in the case of Part 8A of the Financial Services and Markets Act 2000, to ensure that the UK can continue to respond to requests for information from overseas regulators. The UK intends as far as possible to maintain a mutually beneficial working relationship with the EU, in the same way we currently co-operate with non-EU regulators under the existing provisions of the Act.
It should be noted that, in accordance with the comments we received from the Secondary Legislation Scrutiny Committee, the Explanatory Memorandum for this instrument has been revised and relaid. The revisions to the Explanatory Memorandum provide further clarity on amendments made to ensure that UK firms could continue to use UK sovereign credit default swaps to hedge correlated assets or liabilities outside the EU. It addressed why amendments had not been made to the buy-in procedure in Article 15 of the SSR, clarifying that this is repealed by Article 72 of Regulation 909/2014 and that, given that will not be in force before exit day, we cannot use EU withdrawal powers to enable it. A separate instrument will make this amendment. Lastly, it clarified that notifications given to the FCA continue to be effective for exemptions for market-make—therefore, they will see no change.
In summary, the Government believe that, should the UK leave the EU with no deal or implementation period, this SI will provide for a framework to regulate short selling and certain aspects of credit default swaps effectively post exit.
I hope that noble Lords will join me in supporting these regulations. I commend them to the House and beg to move.
It is fair to say that when this legislation was negotiated, a lot of it was directed against the markets in London, so if anyone is worried that the regime will run without so many requirements for consultation, it should not be the UK. I had the advantage of participating in scrutiny on Sub-Committee A of the Secondary Legislation Committee, on which I sit. As the Minister explained, in consequence, there has been an extension to the Explanatory Memorandum, and I thank him for that. The correspondence about that is in Appendix 2 to the report. As he said, it mainly concerns the use of sovereign credit default swaps for hedging purposes. That is the single issue to which I shall return.
By way of background, sovereign credit default swaps and their short selling was a highly contentious issue at the time of the eurozone sovereign debt crisis, with many wanting to ban sovereign CDSs altogether, blaming them for escalation to the crisis. It took several months of my life turning that around to establish that there was such a thing as legitimate hedging of correlated assets. Due to that sensitivity, it is worth more clearly explaining that in consequence of changes made in the regulation, there is a widening of the scope of the assets that sterling CDSs could be used to hedge—which, again, the Minister explained— which happens by removing the EEA reference and replacing it with a global one. I do not object to that widening—there was a choice between narrowing or widening, and widening probably goes with the open approach of the UK—but it means wider possible use of sterling credit default swaps. I want to ensure that that is properly understood, should anyone ever read this debate.
It would also be worth knowing what, if any, assessment of the additional volume that is expected to create, if any such calculation has been done, especially in the event of a no-deal Brexit, when some more chaotic things may be happening of the variety that was of concern during the eurozone sovereign debt crisis. I am still confused why Articles 8.4, 8.5 and 8.6 of the delegated act regulation have been deleted. Deleting those paragraphs removes the requirement for a Pearson correlation coefficient of 80% as part of the high correlation definition under Article 3.7(b) of the short selling regulation. The 70% threshold is retained under Article 3.7(c), within Article 18 of the delegated Act. Article 18 was cited in correspondence with the sub-committee as what the Treasury will follow when it takes over setting the correlation conditions.
I do not object to the Treasury taking over setting correlation conditions, because I think it has a good interest in what happens to hedging using sterling CDSs. I just want to know whether 80% is out of favour, whether something happened to replace it prior to the regulation, or whether that change is another widening.
My Lords, I thank the Minister for presenting this statutory instrument. I thank him, first, for forcing me to understand a little about short selling; it took several hours to get a reasonable knowledge of it. What I found most difficult were the various exemptions. I sought help from the department to try to understand them. It was pointed out to me that, in some ways, that was the wrong question. The key essence of much of what we are doing tonight is in Section 8 of the European Union (Withdrawal) Act. I remember the debates on that provision with great care, and the overwhelming requirement of Section 8 is that it should not be used to change policy, except as required for the smooth transition.
I think that perhaps the noble Baroness has brought out an area where there may be a little change policy, and I shall listen carefully to the noble Lord’s response. I particularly noted the narrowing/widening argument; there was no option—one or the other had to be chosen, and the widening choice seems more sensible.
One of the things I learned while trying to understand short selling is that it is not necessarily the evil practice that the popular press held it to be in some of the various crises. It had a role. Nevertheless, it is a powerful tool which, if misused, could destabilise financial systems. Clearly, it is essential that the ability to manage it is carried through after exit day if we are unfortunate enough to leave with no deal. Therefore, I support the statutory instrument.
I thank noble Lords for their scrutiny, and I shall address some of the points raised. The noble Baroness, Lady Bowles, asked why the instrument deletes the provisions on correlation between assets liabilities and sovereign debt in another member state. That is because, after exit, we will be concerned only with the sovereign debt of the UK, so technical provisions on correlation to sovereign debt across the EU will no longer be relevant. They must reference the rest of the world, not just the EU. It cannot be confirmed at this stage what impact this may have on the volume of instruments that are traded.
The noble Lord, Lord Tunnicliffe, asked whether this SI potentially challenged the principle of no policy change. Like all SIs we are making under the European Union (Withdrawal) Act, this is not intended to make policy changes except where necessary to reflect the UK’s position outside the EU and aid a smooth transition. Changing the scope is an example of where a change was necessary, as noted by the noble Baroness, Lady Bowles. She also asked about the reference to Article 15 of the SSR. The SI needs to be made to provide the UK with an effective framework to regulate short selling and certain aspects of credit default swaps after Brexit. By not approving this instrument, the FCA would not have the necessary oversight of UK markets in relation to short selling, which, of course, would be a precarious position to be in.
The noble Baroness, Lady Bowles, asked about the change in the use of sovereign CDS positions for hedging purposes. As references to member states are being replaced with the appropriate UK reference, the provisions around cross-border hedging would be deleted. To ensure that firms can continue issuing UK sovereign credit default swaps as a hedging tool, development provisions have been onshored to allow market participants to use UK sovereign CDSs to hedge assets or liabilities located anywhere in the world.
The noble Baroness, Lady Bowles, asked about thresholds. Any future CDS correlation thresholds will be future policy, and it will be a decision for the Treasury. I think that that deals with most of the points raised in this debate, and I commend the SI to the House.