The European Union’s new proposals on short selling address a practice that supposedly contributed to recent financial crises. But there is still too much misunderstanding of short selling, and these wide new powers bring dangers of their own.
It is easy to point the finger of blame at those who borrow shares they believe will fall and buy them back at a profit. Finding short sellers at the scene of every disaster, naïve observers confuse correlation with causation, and ignore the valuable service provided in the early discovery of overvalued stock.
Politicians attacked short sellers as “spivs” after HBOS shares plunged in 2008, leading to a takeover by Lloyds. But it soon emerged that borrowed stock, a clear measure of short selling, was just three per cent of available shares, a level typical for the UK.
The Lehman bankruptcy report by Anton Valukas this March found that Lehman’s available liquidity and the actions of its senior executives and auditor were central to its collapse –?yet former Lehman CEO Richard Fuld wrongly blamed short sellers and sought a naked short selling ban before bankruptcy was filed.
Short selling was actively involved in a market collapse this May, but that was because the German government banned some kinds of short selling overnight. Billions were wiped off the major European indices, with the FTSE falling 2.8 per cent. The new EU regulations restrict such “rogue” actions at a national level. But if the result is pan-European bans of uncertain length, it will be scant comfort.
There’s little evidence that bans help. Research on the SEC’s 2008 ban by Ekkehar Boehmer, Charles Jones and Xiaoyan Zhang (2009) found no clear evidence that it helped stem a collapse in share prices. Alessandro Beber and Marco Pagano (2010) looked across all the global bans and concluded “the overall evidence indicates that short-selling bans have at best left stock prices unaffected, and at worst may have contributed to their decline.”
Despite the eagerness of many to blame the messenger, short sellers spot companies with real problems. Cracking down on them won’t make these problems go away –?they will just take longer to become public.
AT A GLANCE | EUROPEAN SHORT SELLING PROPOSALS
If the European parliament and 27member states agree, the two laws to reform short-selling and derivatives will come into effect in 2012. Negotiations with countries and lawmakers, however, could water down the rules.
Commission officials want to introduce standardisation to the derivatives markets such as interest-rate swaps that bet on borrowing rates. This would make trading more transparent and easier to move from over-the-counter to exchanges, where it can be easily monitored.
The rules will ask derivative traders to use clearing houses which provide a safety net in the event of a collapse like Lehman Brothers, by stepping in should either buyer or seller to a trade go bust.
The proposals make it mandatory to report all trading to central data banks or repositories, which will make it possible for regulators to keep tabs on the market
Industrial companies will be given exemptions, provided their use of derivatives does not pass a threshold that will be set up the new European supervisor.
All trades involving short-selling will be flagged as such. Smaller short positions will be shown to the regulators while traders will be obliged to publicly post big short positions – where the value tops 0.5 per cent of the market value of the company concerned.
If a seller cannot close a short sale after four days by coming up with the assets he promised to sell, the regulator can force him to pay the buyer cash instead. A fine can also be imposed.
The markets watchdog will also be able to prohibit short-selling for three months at a time. Regulators can also impose a one-day ban if the price of a financial instrument suddenly dips.
The rules also introduce tight controls for "naked" short selling, when sellers have not arranged to borrow the assets such as company stock they promised to sell.