Is the price-depressing impact of short selling rearing its ugly head again? With all of the regulatory buzz now surrounding this area, you might believe so. Equity markets are still depressed, some believe by aggressive short sellers, so it is no surprise that circuit breakers and short position disclosures are breathing new regulatory life. Each is under active consideration by the Financial Services Authority (FSA) and Securities and Exchange Commission (SEC). Regulators have a tough balancing act, however. They are recovering from their rushed short selling bans in the darkest days of 2008, while trying to prevent further share swoons, and balancing this concern with the health of hedge funds and other key buy side investors.

Recent disclosures by Morgan Stanley of its short position in Standard Chartered as well as previous disclosures by hedge fund Paulson & Co shorting Lloyds, Barclays and RBS have brought the practice of short sales into the forefront in the U.K. This, after the FSA lifted the ban on short sales of U.K. financial sector firms on January 16, and recommended new requirements that would apply to all U.K. listed firms. Below we examine what short selling is, the global reaction to short sales of financial sector shares in September of 2008, and recent proposals by the FSA and SEC to address short selling in the future.

As background, short selling is a commonly used trading strategy (often but not always for hedging purposes). Though it is generally associated with hedge funds, it is also a common practice of pension funds, insurance companies and investment banks. In any case, it involves borrowing and selling shares that an investor expects will fall in price, with the intent of later purchasing the shares at the lower price and keeping the difference. These types of short sales are considered a “covered short sale” since the investor usually has the requisite number of shares to cover the short when the transaction is closed. A second flavor, guiltily known as “naked short selling,” is where the short seller doesn’t own or borrow the shares they are shorting, but rather places a speculative downward bet on prices.  This tends to carry more risk since the investor has to come up with the shares to close the transaction.

Short selling can be sharply pro-cyclical and exaggerate share price changes, up or down.  Most fears attach to when shares prices are dropping, as more investors short the shares and drive prices further downward.  However, analogous fears arise where share prices rise, as desperate short sellers affect prices by seeking to close out their positions to minimize any losses.

After the Lehman Brothers bankruptcy and the reverberations it caused on other financial institutions’ share prices, the FSA and SEC led the way in organizing a temporary ban on the short selling of designated shares representing financial institutions in mid-September 2008. This was done in the hopes of avoiding pro-cyclical price drops, assumed to be the role of short sellers in exacerbating the price collapse.  The effectiveness of the bans has been hotly debated with many investors claiming the temporary bans created more confusion than stability and, in an unintended chain reaction, negatively impacted the financial performance and viability of funds and other investors.

With more time for rational thought, regulators have taken a variety of steps to further shape short selling, involving both more open disclosure of short positions, circuit breakers to slow pro-cyclical trading, and changes to existing bans. First, the temporary bans have been rolled back over time, by the SEC and Canadian authorities in October 2008 and the FSA in January 2009. Other countries are still utilizing the bans. For example, Australia recently announced an extension of its short sale ban through May of this year.

Second, in the U.K., as it was lifting the temporary short sale ban, the FSA also extended the disclosure requirements by investors in financial sector companies until June 30. Investors are required to disclose short positions of 0.25% or greater and each 0.1% change above that of a company’s capital interest. On February 6, the FSA issued Discussion Paper 09/01 to address the options for future regulation of short selling. In this paper the FSA proposes to expand public disclosure to the market of any short positions representing more than 0.5% of a listed issuer to all U.K. incorporated companies. The current disclosure requirements of 0.25% for companies conducting rights issues adopted in June 2008 would remain.

Circuit breakers, also discussed as “the uptick rule”, are not under consideration in the U.K., but are in the U.S.  This rule, in its different forms, basically says that no short sale may be initiated on a designated share until the most recent trade is higher than the previous price.  The FSA agrees that short selling is a “legitimate investment technique in normal market conditions,” not needing a circuit break.  However, it equally sees benefits for increased disclosure, among them the deterrence of aggressive short selling and the reduced risk of disorderly markets.  The expansion of public disclosure does provide for increased transparency, but undermines proprietary hedge fund trading strategies thought by some to be their competitive advantage.

In the U.S., the SEC is again looking at instituting some form of a “circuit breaker” for shares that are being negatively affected by short selling activity. Though it had been a long-standing rule, established after the 1929 market crash, the SEC abolished it in 2007. This followed studies claiming the rule had little affect in the markets of that time.  With our now roiled markets, there has been mounting criticism that the abolishment of the rule was a contributing factor to the recent market volatility.  In recent testimony before the House Appropriations Subcommittee on Financial Services SEC Chairman Schapiro stated that she hoped the commission would be able to release a proposal for public comment in April. According to an open meeting notice the SEC is expected to address short sale price test rules at its upcoming meeting on April 8.

As financial regulators continue to struggle with market volatility, they are looking at various measures to bring about stability. Though the overall effects of short selling can have positive impact by increasing liquid markets and providing additional investment strategies; there remains the potential for market abuse through short selling. Regulators recognize this conundrum and are attempting to strike the correct amount of balance between proper disclosure and freely functioning markets. The FSA, through increased disclosure, and SEC, through “circuit breakers”, are taking divergent paths on their way to addressing the short selling market and the perceived risks it poses.

Published:  March 17, 2009