Drawing the Boundaries of 'Naked' Short-Selling by Market-Makers: The Regulatory Challenges of High-Frequency Trading

Abstract

The recent fine issued by the Italian securities regulator, CONSOB, against two Dutch hedge funds that had profited by shorting Saipem's shares, provides an opportunity to reflect critically on two interrelated legal and regulatory questions. First, this case reveals an important and open problem in relation to the regulatory treatment and space of naked short-selling. Second, this essay further delves into the potential application of the market-making exemption invoked by the Dutch hedge funds, that critically operated as high-frequency traders. The function of market-making, particularly in the context of automated algorithmic trading, leads to further questioning the meaning and scope of this exemption. 

Key Points • This article looks critically at the fine recently issued by CONSOB against two Dutch hedge funds that executed naked shorts on the engineering firm Saipem • The hedge funds, operating via high-frequency trading (HFT), were listed as marketmakers and thus relied on the exemption under art.17 of the EU Short-Selling Regulation • CONSOB provided a much-needed delineation of the scope of the exemption, clarifying that while the hedge funds were abstractly listed as market-makers, their trading strategy did not reflect a market-making activity • This case provides an opportunity to define the boundaries between covered shortselling on the one hand, and uncovered (regulated) practices on the other hand • Finally, this article sheds light on the business model and incentives within HFT, which inevitably push the boundaries of the above distinction.

Keywords: Short-selling, High-Frequency Trading, Market-making, EU Short-selling Regulation, CONSOB