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Talk to us: blackfriarsresearch@protonmail.com How hedge funds and other market participants could hide and disguise their true short position’s exposure and further intension Is there a way for short-sellers, before and after a short attack on a public company, to create a false and misleading picture of their actual short position exposure and about their further intentions? The German financial conduct authority, also known as BaFin, does provide the following explanation of the EU Shorting Selling Regulation and transparency requirements for shares at their website. The EU Shorting Selling Regulation sets out transparency requirements for shares, sovereign debt, and, subject to certain conditions, sovereign credit default swaps (CDSs). The purpose of notifications of net short positions is to provide the competent authorities as well as ESMA (to which certain notifications and positions are forwarded by the national authorities on a quarterly basis) with an overview of the net short positions that are potentially relevant by reason of their size. A two-tier transparency system exists for net short positions in shares. In the event of a net short position reaching or falling below the relevant thresholds, the net short position must be notified to the competent national authority (Articles 5 and 6 of the EU Short Selling Regulation). Pursuant to Article 5(1) and (2) of the EU Short Selling Regulation, a first-time notification must be made if the net short position reaches 0.2% of the issued share capital of the issuer concerned (first tier). Pursuant to Article 6(1) and (2) of the EU Short Selling Regulation, the net short position must additionally be published in the Federal Gazette (Bundesanzeiger) (publication in the Federal Gazette only) if it reaches 0.5% of the issued share capital (second tier). Source: (https://www.bafin.de/EN/Aufsicht/BoersenMaerkte/Leerverkaeufe/Transparenzregelung/transparenzregel ung_node_en.html) In this research report, we will exclusively focus on German public listed companies, which are regulated by the BaFin and fall within the BaFin jurisdiction. BaFin performs statutory tasks such as ensuring financial stability, the stability of individual institutions and companies, market integrity, and the protection of consumer’s collective interests. The strategies discussed and presented in this research report might similarly work in other jurisdictions as well. For demonstration purposes, let us take the case of the German publicly listed company Wirecard AG (ISIN: DE0007472060). Wirecard AG is a global internet technology and financial service provider which is publicly listed in Germany and is included in the DAX30. On October 15, 2019, there was once again a negative article published by a Financial Times reporter, which was likely the cause of a significant share price plunge afterward in the shares of the Wirecard AG. Let us take a look at the table of net short positions published in the Federal Gazette website (Bundesanzeiger). The following net short positions and net short position changes were published on December 24, 2019. In total, there are five different market participants that either reported a new short position or an increase or decrease in a current short position after October 15, 2019. Note: This report was created before January 01, 2020. Page | 1 Data source: (https://www.bundesanzeiger.de/ebanzwww/wexsservlet) Page | 2 We will now examine three possible scenarios that would all result in the disclosure of the net short positions shown in the table above. All three scenarios have in common that they are fictional since the author of this report does not have superior information and has instead to rely on the net short position magnitudes disclosed through Bundesanzeiger. Scenario 1 First, we focus on the picture the reported net short positions might draw for the average retail investor. In diagram 1, the grey surface shows the adjusted share price of the Wirecard AG at the close of each trading day in Euro. The red line is the accumulated reported net short position, as reported in the Bundesanzeiger after October 15, 2019. Therefore, it is the lowest possible level of accumulated reported net short position in Wirecard AG. We implied that all market participants who had to disclose their position under the law did so. Most websites and other media will likely propagate some of the information given by diagram 1 as a given fact and the correct net short position exposure of market participants. They might, therefore, derive, from the given information, an overall increase in net short position exposure by short- sellers after October 15, 2019. Although it could be logical to draw that assumption, it might still be rather implausible that none of the disclosing parties had a short position before October 15, 2019. The reason is that in general, market participants who take short position exposure in companies are likely to be more sophisticated than other market participants. Those sophisticated investors are likely generally better informed about upcoming events. It seems plausible that the disclosing parties had a position between zero and 0,49% net short exposure before October 15, 2019. Which directly leads us to scenario two. Data source: (Yahoo Finance, Bundesanzeiger, Wirecard AG) Page | 3 Scenario 2 We now move on and look at a second scenario. Let us assume now, before October 15, 2019, all short position holders who reported a net short position in Wirecard AG shares through Bundesanzeiger already had a short position of 0,49%, which makes them first-time notification (first tier) net short position holders. However, since they are under 0,5%, they do not have to be reported as a second-time notification (second tier). As long as they are only first tier, that means their net short position is not publicly disclosed (Bundesanzeiger). The resulting situation is illustrated in diagram 2. The red line now demonstrates the net accumulated short position given scenario two. The increase in the net accumulated short position since the publishing of the report would in the resulting situation only be 2,15% and not 4,60%, as illustrated in scenario one (diagram 1). So, the net short position increase would be significantly lower than in scenario one. Someone taking scenario one as a given fact could likely be misled about the disclosing party’s intention after October 15, 2019. Important to mention is that the resulting situation also makes a huge difference when we look at the average share price to which the disclosing parties went short. The share price to which the funds would have to close their short position before making a loss would be much higher than the price, someone taking scenario one as a given fact, might anticipate. While scenarios one and two are still showing an overall increase in net short position after October 15, 2019, an overall increase in accumulated net short position exposure does not have to be the case, as the author will illustrate in scenario three. Data source: (Yahoo Finance, Bundesanzeiger, Wirecard AG) Page | 4 Scenario 3 In scenario three, we will now assume there are other “friendly” hedge funds (further referred to as FHF’s). An example of such an FHF could be Citadel Europe LLP, who reported a decrease to 0,48% net short position on 25 September 2019. While Citadel Europe LLP had before 25 September 2019 reported a net short position higher than 0,49% and had, therefore, to disclose as a second-time notification (second tier) when the funds decreased their holding under the 0,49% threshold, market participants might assume or be aware of that Citadel Europe LLP had on October 15, 2019, still a net short position in the Wirecard AG shares. Market participants might not be aware of FHF’s, who have been entirely under investor radar since they have always been under the 0,49% threshold. For scenario three, we will assume there have been 25 FHF’s, on October 15, 2019, who have all been short Wirecard AG shares. Each of the 25 FHF’s has been under the 0,49% threshold, so other market participants might not be aware of the enormous total accumulated net short interest in Wirecard AG shares, which would sum up in a scenario where each FHF is net short 0,49% to a total accumulated net short interest of 12,25%. If we add to this number the net short position exposure, we assume in scenario two, the net short position exposure of the position holders would sum up to be 14,7%. These figures are, of course, only assumptions based on the hypothesis that sophisticated market participants might have had superior information before October 15, 2019. If those FHF had now decreased their net short exposure after October 15, 2019, the overall number of shares being short would have also decreased. In diagram 3, a situation is drawn were the FHF’s are steadily decreasing their net short exposure to zero. In that scenario, as illustrated in diagram 3, we would have gone from 14,70% net short exposure to just under 4,60%. Of course, in the real world, we have asymmetric information, so we do not know where the real net short exposure of market participants is at a specific point in time. In theory, the net short exposure can exceed 100%; in such a case, shorted shares are bought, sold and lend again. That means in theory that we could have had any level of accumulated net short position exposure, prior October 15, 2019. What scenario three is here to show is that it is possible that the picture drawn by BaFin transparency requirements is not reflecting the actual true net short exposure and is, therefore, creating a false and misleading picture. It is feasible that sophisticated market participants may use disclosure requirements to mislead other parties about their intentions. Market participants should also be aware of the fact that in addition to the facts mentioned above, it could be possible that the short position disclosing parties are in fact, market neutral or even in a long position in the company, they do report a short position. How is that possible? Only as a hypothetical example and for demonstration purpose, we take Slate Path Capital LP to demonstrate the point. The fund could have been net short prior October 15, 2019, up to 0,49%. In that case, the fund would have opened a new net short position of the magnitude of 0,81% after October 15, 2019. If now in the same period of time, a “friendly” hedge fund would have gone long in Wirecard shares to the magnitude of 1,30%, the overall position of the two funds accumulated would have been market neutral. Following the same principle, the combined position could have also been a long position, if the long position magnitude of the FHF would have exceeded 1,30%. As long as the long position does not exceed the legal threshold, other market participants might not be aware of the long position the FHF would have in the illustrated case. Page | 5 Data source: (Yahoo Finance, Bundesanzeiger, Wirecard AG) Why would market participants be interested in creating a false and misleading picture of their true net short position exposure and about their further intentions? Generally, it is only consequential that the public actively observes institutional investors and other sophisticated market participants. Since the general public might see them as having superior information. Therefore, other market participants might act on the actions they observe by those market participants. Since sophisticated market participants are likely aware of the influence their observable actions might have on other market participants, there might be an incentive to mislead the public about their true intentions. It must be stated that these potentially misleading actions alone might not be statutory offense, and seem to be within the law. The overall problem that short-sellers have is that they do not just need a decreased price in the stock they are short. They also have to buy back the volume of shares they are short at the decreased price. Since the buying back of shares at the decreased price could lead to a spike in the share price, they might be incentivized to create a misleading picture about their actual net short exposure and their further intentions. Also, if their feeling about a stock should have changed at a given decreased price, they might even want to buy an increased volume of shares exceeding the net short exposure they had before the price decrease. They might even build up a long position in the stock, meaning they need sellers at a given decreased price. Page | 6 Summary: BaFin EU Shorting Selling Regulation and transparency requirements for shares and the required public disclosure give fragmentary and incomplete information about the real net short exposure of market participants. It is feasible that some parties are not aware of that others might use the disclosure landscape to mislead them about their true intentions, to be specific, whether they are long or short a stock. It is again feasible that sophisticated hedge funds might use such strategies, as illustrated above, after activist short attacks to hide and disguise their true intentions and to mislead other parties. Although highly hypothetically, it could also be attractive for some hedge funds to use such a strategy, as presented in scenario 3, in combination with so-called short and distort market manipulation schemes. The current EU Short Selling Regulation and transparency requirements for shares and other derivatives might provide not only little help for a level playing field but also the prevailing rules might create even significantly larger differentiating competitive conditions. Not only that, the EU Shorting Selling Regulation and transparency requirements could also create for some market participants a false and wrong faith in their personal knowledge and information with respect to the other party’s intentions. Further, the very existence of a net short position disclosed following a sharp price decline can weigh heavily on the fundamental value of a company, independent of the made allegations in the activist short report itself. The reported net short positions seem to “confirm” the pricing of the market and can undermine investor confidence in the company and thereby deter investors from immediately repurchasing significant quantities of the company’s stock at its depressed value, which would lead to a price increase. Crucially, this loss of investor confidence may have nothing to do with an alleged misstatement or omission by the issuer. It might instead be the significant retail shareholder base amount, which tends to place greater weight on the price itself as conveying information about the fundamental value of a company. It should be stated that a large literature in finance examines learning from prices. The publicly reported net short position exposure of sophisticated parties could, therefore, lead to price distortions, over a specific amount of time, as market participants conclude that it would be dangerous to counteract parties with possibly superior information about the company and its fundamentals. Finally, it also has to be mentioned that there are data provider technology companies, which claim to possess superior net short interest data. The author of this report urges the public to be highly skeptical about that data, especially but not only if those data sources are free of charge. The incentives of data providers may not be aligned with their data users, which means there might be a conflict of interest. There might be further aspects to this topic the author overlooked or deliberately has not mentioned. This report does not, in any sense, claim to be comprehensive and is far from being complete research into the topic. The report was created before January 01, 2020. 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