With Covid-19 sending the market into free fall, it seems that regulators across the globe are divided on what to do about short-selling. While some European countries such as Italy and Spain have introduced bans to protect certain vulnerable stocks from predatory hedge funds, others, like the FCA, have ruled out the possibility of a ban.
Short-selling has always divided opinion. Some view it as a cold and callous way to profit from a company’s downturn, whereas others consider it an important source of market liquidity and price formation. It’s unlikely we’ll reach a conclusion on the morality of the practice, but given we are currently experiencing a pandemic, the likes of which we haven’t dealt with since 1918, perhaps the debate needs to shift towards a more pragmatic discussion about the way it functions.
Read more: FCA say no short-selling ban on the cards
Obviously the argument about price formation does not apply in the same way at this time. A company that is heavily shorted because of poor corporate governance or a misguided business model is not the same as a company that is reeling from the effects of a crisis that is far beyond their control.
One of the biggest problems with short-selling is the ‘fear factor’. For example, if a bearish financial statement is published, short-sellers are able to jump into gear, while also declaring their reasons to the wider markets. This can be damaging, not only to the share price, but also to investor confidence, which is already low.
To minimise unnecessary further struggle, a sensible way forward could be to limit the quantity of shares that are held by shorts. If there is a restriction on exactly how many shares a short-seller can borrow in a company, then the kind of fear that can spread amongst investors like wildfire is likely to diminish. To start with, a proposed restriction could be tested out on the most heavily shorted stocks in the FTSE 100. Say, for example, hedge funds could only short a liquid FTSE 100 stock that has less than 5% of its shares out on loan. After all, a short position can only be put on providing the seller can borrow shares in the first place.
This cap level may not be fair if the price of the firm in question should legitimatelybe lower because it is poorly managed. But a cap is not designed to restrict short positions held for a limited time. It’s more geared towards curbing permanent short positions that remain as a large black cloud that could potentially hang over companies after this crisis has blown over. If successful, it is not beyond the realms of possibility that a similar cap could be rolled out for companies listed on other indices.
There is, of course, no guarantee that a restriction on the number of shares held by short-sellers would lead to some kind of utopia for the market. Clearly some important questions would need to be asked first including – how exactly would a regulator identify which stocks are being over-shorted? Should shorting be monitored on a company by company basis? And, perhaps most crucially of all, what would be and who decides on a sensible limit to impose at this time?
If these questions could be answered, then at least the seemingly never ending debate about how short-selling should operate can take a step in the right direction. And although an outright ban is neither feasible nor desirable, maybe regulators should explore other options to make sure that shorting doesn’t get out of hand at a moment when many valuable businesses need all the help that they can get.