Short Circuit

European finance directors were no doubt shocked by financial markets regulators making the snap decision to ban short selling in markets across the world. Moves to ban the practice of shorting publicly listed financial institutions have probably protected their share prices from spiralling downward. But the ban on short selling also has other wide-reaching and not so popular ramifications for financial markets and the companies that are traded on them.

Immediately after Lloyds TSB announced its £12.2 billion takeover of the UK’s biggest mortgage lender HBOS plc on 18 September, the board of the UK Financial Services Authority (FSA) announced it was banning the ‘active creation or increase of net short positions in financial institutions’ for 120 days. From 23 September, it has also required investors to disclose on a daily basis any net short positions in excess of 0.25% of the ordinary working capital of financial institutions traded on stock exchanges. There is an exception for market makers to allow them to meet client demand.

On 19 September, the US Securities and Exchange Commission followed suit, announcing an immediate ban on short selling in financial institutions to combat aggressive trading of stocks in this sector, with a similar exception to the FSA.

Market consequences

The decision by regulators to ban short selling – that is, the way in which investors sell stocks they do not own with the intention of buying them back at a later date for a lesser value, thus making a profit – has been widely regarded by market participants as a knee-jerk reaction. Although it may have stopped destructive shorting of some stocks, it also means institutions may be not able to hedge positions. This in turn means they will not be prepared to fund certain deals whose risks they cannot hedge by taking out a short position, which will have far-reaching consequences for finance directors if they are not able to secure project finance.

Commenting on the recent changes to short-selling rules, Richard Davies, who runs investor relations consultancy RDIR, in London, says ‘the recent spate of total or partial bans on short selling across the world’s capital markets is a knee-jerk reaction by governments and regulators faced with market turmoil for which they were scarcely prepared. Hedge funds have once again become the lightning conductor for the anger directed against the financial community by commentators, politicians and the suitably whipped-up general public. Hedge fund managers are thought of as spivs, parasites or speculators. The pressure’s now off public company directors; the denizens of Mayfair are the new ‘fat cats’.

Davies, though, is reluctant to blame hedge fund traders for the crisis and is sceptical that closing off hedge funds’ foundational investment strategy of going long-short will make any difference to market prices in the long term.

‘While hedge funds were in many cases traders of toxic assets, it was not they who persuaded the banks to take huge positions in bad debt instruments,’ says Davies. ‘Selling short financial firms that have badly managed their risk seems a fairly sensible approach as the prognosis for these companies cannot be good, now that the bad stuff has hit the fan. Even if short-selling exacerbates the banks’ share price declines – and most funds would argue against that proposition – one could argue the prices are heading south anyway. The stock lending figures available in the UK for banks during the recent crisis showed that short positions were relatively low, so the impact on valuations has been vastly overstated.’

According to Davies, financial markets will suffer if shortselling continues to be banned. ‘What happens then?’ he asks. ‘If hedge funds go to the wall, then what happens to their investors? These used to be just high net worth folk, but in the last few years we have seen major investment by institutional money, including pension funds looking for sexy outperformance in a world of flattening returns from the more traditional asset classes. The investment banks’ trading desks are also big investors, so any losses on this side will further exacerbate the banking crisis.’

Others are more supportive of the move to ban short selling. ‘In normal times, the ability for an investor to sell a stock short is a legitimate tactic by investors, and most often part of a hedging strategy,’ says Mark Hynes, managing director of advisory firm Transparency Matters. ‘Short selling creates much needed liquidity. But these are far from normal times, and the ban on short selling is to be welcomed. With the twin evils of alleged market abuse, as rumours sweep the market achieving the very result that short sellers want, and leverage of banking assets for short selling and other purposes, regulators have had very little option but to suspend this activity. Most seem to be opting for a 120-day period. Whether that is sufficient for confidence to be restored remains to be seen.’

The focus on shorting kicked off at the start of June 2008 when the FSA made a snap announcement that investors short by more than 0.25% of a stock’s total market capitalisation when the company is undertaking a rights issue must disclose their position to the market. Companies and the market were perplexed by the new rule, which offers finance directors little in the way of new information about trading in their shares.

This rule was the first time in the UK that short sellers have had to disclose their position in a listed company. In its announcement, the FSA said the decision was taken to combat the potential for market abuse in relation to rights issues when there is a falling market. This was a reference to the FSA’s concern over the dramatic 17% drop in HBOS’s share price after it announced a rights issue. The FSA viewed the sharp fall in HBOS’s share price as a consequence of market abuse, and so mandated disclosure of substantial shorts to prevent similar situations occurring in the future.

Hot on the heels of this announcement was another FSA missive that requires contracts for difference (CFD) investors to disclose when they are long more than 3% of a stock. It is currently conducting consultation on how implementation of this rule will progress.

Impact of the new rules

So what do these new rules mean for finance directors and listed companies? ‘We don’t think the new rules are all that brilliant,’ says Will Duff Gordon, managing director of stock lending data firm Data Explorers. This is because just disclosing whether a position is short does not give listed companies a full understanding of investor sentiment in the stock. To illustrate, Duff Gordon points to a disclosure by hedge fund Jabre Capital regarding a short position the fund took over when HBOS was undertaking a rights issue.

‘The company was an underwriter of the issue, so the short was for hedging purposes,’ he says. ‘Anyone who’s underwriting a right issue is likely to do the same thing.’ So information on the volume of short selling is of limited use because such information makes little sense without an understanding of the context of the trade.

A similar example is short selling in relation to derivatives hedging, which is a large component of short activity. This is a practice in which market participants lessen risk by taking a position in a stock whose value responds to the opposite position a client has taken in a stock. The wholesale fund or insurance company executing the trade would not necessarily have a negative view of the particular stock; rather their activities should be seen as prudent risk management.

Index arbitrageurs also regularly short stocks: they trade on the relative mispricings between the futures market and the stock market by buying in the market that is cheap and simultaneously selling the market that is more expensive. But again, traders do not necessarily have a negative view of the shorted stock in this type of transaction.

Aside from the limitations of such information, Duff Gordon says there is also concern that the new rule will prevent companies from undertaking rights issues. ‘Perhaps these rules will make rights issues less popular, but people are moving away from rights issues anyway because they are not the best way to support a balance sheet,’ he says.

Hynes says the new rules will have little relevance for finance directors of listed companies. ‘There are only limited benefits for corporates,’ he says. ‘It will only really highlight shorting in their stock, that’s all. And shorting is seen by companies as having many uses such as creating liquidity.’

Hynes also thinks the rule will have limited effect because it only applies to rights issues and not other financial instruments or transactions. But, unlike Duff Gordon, Hynes does not think the new rule will prevent companies from undertaking rights issues.

‘Rights issues are not popular anyway, although banks are doing them, but that’s a different story,’ says Hynes. ‘They do them when their options [for raising funds] are limited. Rights issues will happen anyway and this will just put shorting related to them out there.’

Companies are also loath to embrace the new rule. ‘Short selling is a fact of life in today’s financial markets, providing much needed liquidity,’ says a senior finance executive at one of the UK’s largest telecommunications companies. ‘Insisting on naming and shaming short sellers is unlikely to deter them. Certainly, we would not find the names of those shorting our stock particularly useful information. The new rules seem misconceived.’

The popular choice

Although companies and investors have yet to warm to new rules about disclosure of shorting, there are more supportive of the recent rule that will increase disclosure of long positions related to CFDs. Under the new rule, investors who are long more than 3% in a company’s shareholding by taking a position in a company’s stock through either through CFDs or regular equities or a combination both will be required to disclose this to the market.

‘This is a terrific result from the FSA consultation for listed companies and for the wider market, increasing transparency,’ Hynes says. ‘The only downside is that the rule will take an age to implement.’

Finance directors have also been supportive. According to Alliance Trust finance director David Deards, CFDs are legitimate financial instruments that allow investors to take an economic interest in securities without having directly to purchase the shares.

‘We believe large holdings should be disclosed in the same way as is required for direct holdings of stock,’ he says. ‘CFDs can obscure the transparency on security trading and share ownership, which is essential to the efficient operation of securities markets. Companies need to understand who has an economic interest in their stock and, where these interests are large, the market should have access to that information as well.’

Davies says he is supportive of the new rule in principle, but argues the FSA should consider introducing a general threshold for disclosure for shorting at 3%, bringing market disclosure rules into line for all shareholder economic positions. ‘Our view is that transparent markets are better for all, but there needs to be a certain threshold under which investors can take a position without the rest of the market knowing,’ he says.

It’s likely the EU will follow suit with this rule as well. ‘Normally the EU will have a look at big new rules like this,’ says Hynes. ‘Over a period of time it’s likely the Transparency Directive will be changed to include disclosure of CFDs.’

Keeping an open mind

Broadly, commentators would like to see much more consultation, rather than a knee-jerk reaction from the FSA over increased disclosure of shorts and derivatives.

‘We have an open mind as to whether more information on shorting would be valuable,’ says David Rule, chairman of the Securities and Derivatives Industry Association. ‘In 2002, the FSA did a proper review of shorting disclosure and found that the costs of position reporting outweighed any benefits, although they did ask the settlement system CREST to publish regular securities lending data. I wouldn’t mind the FSA having a look at that again, provided they do so with full consultation and give firms notice before implementation.’

In early August, the FSA concluded a review of the HBOS situation and found although ‘there is no doubt that false and damaging rumours were circulating about HBOS on 19 March 2008 and these would have had some impact on HBOS’ share price’, it is hard to say how much impact the rumours had as the share price was also affected by a lack of liquidity in the order book, as well as algorithmic trading strategies that amplified the downward trend in the stock price.

The FSA is now conducting a review of investment firms’ systems and controls for dealing with rumours. It has said the most recent provisions will remain in force until 16 January, although they will be reviewed after 30 days. It expects to release a comprehensive review on short selling in January.