FRA Decision Regulating Short Selli

The Board of Directors of the Financial Regulatory Authority ("FRA") recently published on the FRA website decision No. 268 of 2019 (the “Decision”),[1] dated 26 February 2019, regulating “lending securities for the purpose of selling them”, otherwise known as “short selling”.

General Concept

Short selling is a known mechanism in world financial markets that allows holders of listed securities ("Lenders") to make such securities available to investors ("Trading Borrowers") who wish to borrow the same in order to sell them in the market. Given that the Trading Borrower must buy back similar securities at a later date and return them to the Lenders, such Trading Borrower is able to speculate on the decline in price of the borrowed securities; which ultimately increases liquidity in the market.

Transaction Parties

The Decision regulates the relationship among the different parties involved in a short selling transaction, primarily:

• The Trading Borrower, who wishes to carry out the short sale transaction and is willing to take that risk;

• The Lender, who owns the securities and wishes to lend and then recover them with profit;

• A Securities Brokerage Firm that manages the borrowing, selling, buying, and retrieving of securities on behalf of Borrowers and Lenders; and

• A Custodian, who enters into contractual agreements with Lenders to manage their securities and establishes a "portfolio of securities that are available for lending", which is a portfolio combining all securities available for lending to various Borrowers.

Brokerage Firm Conditions

Short selling can only be undertaken by a securities brokerage firm that is licensed by the FRA to do so. Therefore, firms wishing to undertake short sale transactions must obtain an additional approval from the FRA, which requires the following:

1. The company’s net equity rights must not be less than EGP 5 million. If the company wishes to simultaneously undertake margin trading, the shareholders equity must not be less than EGP 10 million.

2. The company must submit to the FRA a list of documents that is specified in the Decision. This includes: a statement of net liquid capital (which must not have been less than 15% during the previous six months), the total liabilities of the company, the latest audited financial statements, a report on the electronic processing systems and an electronic connecting line and a telephone order registration system, a transaction log system and documents archiving, and internal audit systems.

3. No FRA administrative measures must have been taken against the firm during the previous six months.

4. The number of employees in the department that will be responsible for this new activity must not be less than three individuals who meet certain professional criteria.

5. The company must submit the contract template that it intends to use with its customers.

It is worth noting that the Decision clearly states that FRA’s approval of the applications submitted will be "in light of market's need" which means that the FRA has the right to decline an application even if the broker firm fulfils all the requirements if it decides that there is no market need for it.

Transaction Implementation Mechanisms

• A short sale transaction starts with the Custodian entering into agreements with Lenders making their securities available for lending.

• The Brokerage Firm then enters into agreements with the Lenders to carry out the lending process on their behalf, as well as agreements with Trading Borrowers who wish to borrow the securities with the purpose of short selling. The Trading Borrower must deposit a cash collateral in a separate account with the Brokerage Firm of at least 50% of the market value of the borrowed securities based on the last closing price, or not less than 20% of the market value of government bonds. The Brokerage Firm may agree that such collateral be in the form of securities, and it may agree with the Trading Borrower to reinvest the cash collateral on its behalf in exchange for sharing the proceeds as agreed between them.

• Lenders then instruct the Custodian of their wish to lend certain securities. However, instead of offering these securities on their own, the Custodian adds them to the portfolio of securities that are available for lending from all its clients.

• Once the Trading Borrower informs the Brokerage Firm of its desire to engage in a short sale, the Firm executes the transaction using the securities available in the Custodian’s portfolio. The Brokerage Firm then retains the proceeds of the sale and reinvests the same. The returns of the investment of those proceeds are then added to the Lender’s account held by the Firm, after making deductions for commissions and expenses.

• Finally, the short sale is concluded by the Trading Borrower’s returning of the securities at the agreed date to the Lender’s account. This is done through the Brokerage Firm and the Custodian. The Brokerage Firm then returns the cash collateral to the Trading Borrower. This return of securities could be through the Trading Borrower’s instruction of the Brokerage Firm to repurchase the securities from the market, or by asking to borrow similar securities from the Custodian portfolio following which the Trading Borrower’s liability vis-à-vis the first Lender ends and is replaced with a new liability towards another Lender. The two parties – Lender and Trading Borrower - may agree to renew the contract for another term.

• In the event that the Trading Borrower fails to return the borrowed securities at the end of the term, the Brokerage Firm purchases these securities from the market using the Trading Borrower’s account and informs it of the same, then returns the securities to the Lender.

Financial Regulations

In order to ensure that short selling is executed within secure financial limits, the Decision stipulates that the following regulations must be adhered to:

1. The percentage of securities available for lending via the Custodian must not exceed 25% of the total shares of the issuing company.

2. The percentage of securities available for lending by one Lender must not exceed 5% of the total shares of the issuing company.

3. The percentage of securities that are borrowed by the Trading Borrower (and its related parties) must not exceed 0.5% of the total shares of the issuing company.

4. The Brokerage Firm is obligated to revaluate the borrowed securities at the closing price quoted at the end of each business day against the value of the cash collateral.

5. If the value of the cash collateral falls to 140% in comparison to the market value of the securities, or 115% for the government bonds, the Brokerage Firm must require that the Trading Borrower increases the cash collateral to 150% of the value of the securities and 120% of the value of government bonds. If the Trading Borrower fails to respond within two days, or if the percentage of the cash collateral falls to 130% ؜of the market value of the securities or 110% of the government bonds, the Brokerage Firm must intervene and buy the borrowed securities from the market without the Trading Borrower’s prior consent.

Brokerage Firm Obligations

The new Decision sets out a number of obligations which Brokerage Firms wishing to undertake short sale transactions must adhere to, the most important of which are the following:

1. Observing special care when verifying the ability of its Trading Borrowers to meet their obligations, in accordance with the standard legally known as the "Prudent Man Rule."

2. Enabling the FRA and the Egyptian Stock Exchange to access the accounts and books related to this activity at all times.

3. Managing an integrated accounts system.

4. Notifying Misr For Central Clearing, Depository & Registry (“MCDR”) with the details of all its transactions on a timely basis.

Conclusion

The introduction of comprehensive short selling rules, after years of anticipation and hesitation, will be welcomed by market professionals, international players, and expert investors, as a means to deepen the market, complete the set of mechanisms available in world markets, and improve price discovery and transparency. It is, however, a sophisticated process and one which must be closely monitored and regulated in order to avoid uninformed investors and speculators and negligent brokers from getting involved without sufficient knowledge of its risks. The next challenge is therefore for the Egyptian Stock Exchange and FRA to properly educate the market and protect it from unprofessional behaviour.   [1] FRA Chairman Decision No. 268/2019 regulating the lending securities for the purpose of selling them, available through this link (in Arabic).