Canada needs a measured regulatory approach to short selling, says AIMA

In mid-November, the Canadian Securities Administrators (CSA) and the Canadian Investment Regulatory Organization (CIRO) published a summary of responses and comments to a consultation it launched last year on the current regulatory framework surrounding short selling in Canada.

Drawing from the responses – which included 23 comment letters from industry associations, exchanges, dealers, issuers and investors – CSA and CIRO found a broad range of opinions on the current regulatory regime. Most argued for short selling as a legitimate trading practice, including many who argued the current regime in Canada is sound.

While the regulators are not proposing changes at the moment, CSA and CIRO have indicated they will continue to consider changes as appropriate in the future. They also identified several potential areas for further study, which is certainly needed according to one commentator.

“What often gets lost when we're talking about short selling is that it’s most commonly deployed as part of a long-short trading strategy,” said Adam Jacobs-Dean, managing director and global head of Markets, Governance and Innovation at the Alternative Investment Management Association (AIMA).

“When you have anything in the regulatory framework that constrains or disincentivizes short positions, the overall impact is to also limit the scope for fund managers to take on the associated long positions they would make in a long-short trading strategy.”

Contrary to the popular perception of short-selling being weaponized by vocal activist investors, Jacobs-Dean (pictured above) says that in reality, it’s overwhelmingly used by managers to hedge the risks that may come with the long side of their trading activity.

Europe’s short-selling regime offers lessons

As an international organization, AIMA has a global view on short selling regulation and the different approaches used by jurisdictions around the world. Among the more extreme examples, Jacobs-Dean says, has been a propensity in Europe to outright ban short selling in some member states in times of stress, including the wake of the COVID crisis.

“In the European context, we do have rules requiring individual disclosure and identification of market participants with larger short positions,” he says. “Based on the experience there, which in our view has been a negative impact on market participants, it’s been quite easy for us to express opposition to proposals in Canada around public transparency.”

According to Jacobs-Dean, a move to create additional public transparency around individual firms’ short positions akin to what’s in Europe runs the risk of damaging relationships between market participants and securities issuers, given that issuers do not enjoy seeing their securities shorted. The knowledge of one firm shorting a particular security, he adds, could lead its competitors to follow suit, which could lead to crowding and herd behaviour.

To help reduce the risk of failed trades, the CSA and CIRO also proposed to take a harder look at managers’ practices around locating or pre-borrowing securities for short positions. While AIMA understands the interest in that area, Jacobs-Dean says it’s also important to take a measured approach, arguing that the current approach around reasonable expectations of a trade being able to settle is “something that is workable.”

Mandatory buy-in provisions: a tool of last resort?

The regulatory regime around short selling is also top of mind for the Ontario Securities Commission (OSC). In its proposed statement of priorities for 2024-2025, the OSC said that together with the CSA and CIRO, it would explore the introduction of mandatory buy-in requirements or accelerated fail-to-deliver reporting in Canada.

While it’s difficult to comment without more details, Jacobs-Dean says the European experience on mandatory buy-in provisions is also instructive.

“Europe implemented a settlement discipline regime that included mandatory buy-in provisions, but it was very problematic to implement in practice. It led to the planned implementation of the rules being suspended, and then revisited,” he says. “Ultimately, the outcome was essentially to position mandatory buy-ins as a tool of last resort when failed trades have proven to be systemically problematic.”

One way of approaching the debate around buy-in requirements, Jacobs-Dean says, is to consider where buy-in statutes would fit within the overall range of tools that regulators can use to support settlement discipline. While there’s no question reporting requirements should be a core instrument in the toolkit, he says the operational complications faced in the EU around mandatory buy-ins would suggest they should be reserved as an extreme option.

As Canada’s securities regulators continue to contemplate their approach to regulating short selling,  CSA and CIRO are expecting to form a staff working group to broadly examine issues in the Canadian market, beginning with analyzing potential mandatory close-out or buy-in requirements. Jacobs-Dean says the CSA has been very engaged and open to feedback from AIMA and other industry stakeholders in their discussions, and he hopes that will continue in the context of their coming work.

“We’re quite keen to see a reasoned debate about the role of short selling, and also a measured policy approach,” he says. “We want to ensure that we don't have a framework that unwittingly makes it harder for people to short sell, thereby constraining their strategies and, ultimately, hurting liquidity in the securities market.”