ASIC has issued Class Order [CO 09/774] that allows short selling to hedge risk from market making activities.

Previous exemptions that allowed market makers to ‘naked’ short sell to hedge their long exposures were repealed on 8 January 2009 by the Corporations Amendment (Short Selling) Act 2008.

The class order provides market makers with relief in limited circumstances from section 1020B(2) of the Corporations Act in relation to the sale of a security or managed investment product to hedge risk from market making activities.

The relief contains a number of conditions, including requirements that market makers have reasonable grounds to believe securities lending arrangements can be put in place to allow delivery and market makes acquire or borrow sufficient products by the end of each day to ensure that they can deliver all products sold during the day at the time delivery is due.

The class order was the subject of public consultation in Consultation Paper 106 Short selling to hedge risk from market making activities (CP 106), released for comment on 30 April 2009.

The ASIC class order also reflects international regulatory developments, including the Regulation on Short Selling report by the International Organization of Securities Commissions (IOSCO) released in June 2009. The paper recommended that short selling regulation should allow for efficient market functioning and development, including an exemption permitting market makers to naked short sell to hedge risk arising from their market making activities.

Background

A market maker regularly states prices at which it proposes to buy or sell financial products on its own behalf.

If a market maker enters a transaction with a counterparty that creates a ‘long’ exposure to an underlying product, the market maker may want to hedge the risk of this long exposure by short selling the underlying product.

Section 1020B regulates the short selling of certain financial products. ‘Naked’ short selling is prohibited in Australia—that is, a person selling section 1020B products must, at the time of sale, have ‘a presently exercisable and unconditional right to vest’ the products in the buyer.

A market maker is generally permitted to engage in ‘covered’ short selling of section 1020B products to hedge risk. A covered short sale is a sale where the person selling products has, at the time of sale, a presently exercisable and unconditional right to vest the products in the buyer because of a securities lending arrangement entered into before that time.

Under the current law, market makers are effectively required to maintain an inventory of long or borrowed products. There are practical difficulties for a market maker to borrow an inventory of section 1020B products needed to cover its market making activities at the start of each trading day because:

• the market maker is unable to anticipate the volume of products it will require to cover possible future positions; and

• the market maker will incur borrowing and administrative costs, regardless of whether the borrowed products are actually used and this would restrict the amount of product available for borrowing by others which will increase borrowing costs generally.

Download Class Order [CO 09/774] and the explanatory statement