Short selling crackdown in South Africa

South Africa’s financial sector watchdog has proposed new reporting and disclosure requirements for short sales that will explicitly prohibit uncovered or “naked” short sales.

These new requirements are a revised version of the Financial Sector Conduct Authority (FSCA) initial draft that was published in March 2023.

It comes after extensive feedback from industry stakeholders and is now open for a second round of public consultation.

Webber Wentzel’s Dawid de Villiers, Gabi Richards-Smith, Analisa Ndebele, and Hlompho Moichela said the 2008 global financial crisis highlighted the risks that short sale transactions pose to financial institutions and the broader market stability.

The legal experts said this is particularly risky in times of declining share prices. “These risks include market abuse, disorderly trading, and settlement failures,” they said. 

“In response, several jurisdictions imposed temporary bans on short sales in certain sectors during the crisis.” 

“Since then, international principles and best practices have been developed, notably by the International Organisation of Securities Commissions’ (IOSCO) Task Force on Short Sales.”

Therefore, in line with international best practices, the FSCA’s New Draft Conduct Standard seeks to address the regulatory gap in short sales in South Africa.

The FSCA’s answer to this gap is to introduce a formal framework for the reporting and disclosure of short sales in South Africa. 

The New Draft Conduct Standard will apply to all financial institutions engaging in short sale activity and explicitly prohibits uncovered or “naked” short sales. 

Naked short selling is the practice of short-selling a tradeable asset without first borrowing the asset from someone else.

“The FSCA believes that transparent short sale reporting will enhance market integrity by helping to track the level of short selling in specific securities,” the legal experts explained,

In addition, these new requirements will provide insight into share price movements, offer early warning signals of potentially overvalued individual securities, and build investor confidence by reducing uncertainty.

Phased approach

The legal experts said the FSCA is introducing a phased approach to implementing the short sale reporting and disclosure framework due to practical challenges and the absence of empowering provisions.

In the first phase, only positional reporting of short sales data will be required. The experts explained that transactional reporting has been removed from the the New Draft Conduct Standard. 

This is due to concerns that some authorised users responsible for executing trades typically do not have insight into which transactions relate to a short sale, as clients do not disclose this information to them.

The FSCA’s solution is to potentially propose amendments to the Financial Markets Act that will allow for transactional short sale requirements to be imposed directly on clients.

“Financial institutions conducting short sale activities will be required to report open short sale positions to a licensed trade repository daily unless the positions fall below thresholds that have yet to be determined,” the experts explained.

The FSCA has also approved South Africa’s principal central securities depository and central collateral platform, Strate, as the first licensed trade repository. 

“It is expected that, once the New Draft Conduct Standard comes into force, financial institutions will be mandated to report short sale positions to Strate,” the experts said.

“Where financial institutions do not have the necessary information to determine open short sale positions, they must make a reasonably practical effort to obtain the data.”

Better transparency

Webber Wentzel’s experts explained that positional reporting offers the market valuable insights into the level of bearish sentiment in listed securities at any given time. 

Therefore, changes in reported short positions may help investors assess whether a security is undervalued or overvalued.  

“Overall, enhanced positional reporting is expected to improve market transparency and efficiency, thereby strengthening trust in South Africa’s financial markets,” they said.

The experts explained that once positional short sale data is reported to the trade repository, the repository must publicly disclose aggregated data on its website within one business day of receipt.

“The disclosure will include the total open short positions in a specific security, aggregated across all financial institutions, as well as the percentage of issued shares represented by those open short positions,” they said.

They added that enhanced transparency of short sales offers significant informational benefits for the market, which are expected to outweigh the associated compliance costs. 

The New Draft Conduct Standard also aims to discourage aggressive, large-scale short sales that could disrupt orderly markets or lead to market abuse.  

“Additionally, the early warning signals of a build-up in short positions will assist regulators in identifying and addressing potentially abusive behaviour more effectively,” they said.