Naked shorting and market volatility

In the summer of 2010, amidst the European debt crisis, the German Finance Minister Schäuble, when commenting on the financial industries complaints about financial reform, said “if you want to drain a swamp, you don’t ask the frogs for an objective assessment of the situation”. Inhabitants of the swamp must surely include the short sellers, not least of all hedge funds (“locusts” in the eyes of others) and other groups that provide valuable liquidity and depth to financial markets. Current events show that what is now proposed is anything but “an objective assessment” by key politicians and regulators.

What is short selling?
Shorting is selling assets an investor, such a hedge fund, does not own in the expectation that the assets can be acquired at a lower price at or before delivery, thus generating a profit for the investor.  Shorting has acquired a reputation as the evil twin of “going long” where the hope is that the price will rise and likewise generate a profit. 

Given that markets are heavily driven by those with differing views as to whether a price of an asset should or is about to fall, it is arguable that an investor has a right to act on that belief. Indeed many fund managers argue that a focus on valuations and fundamentals represents the core to any successful investment and that significant falls in equity values can only present further opportunities and is evidence of proper market pricing.

Politicians and regulators beg to disagree and argue that short (particularly “naked” short) selling disrupts markets and causes unnecessary volatility and so should be restricted or banned entirely.

Substantial differences exist between “naked” shorting of bonds, equities and CDS but these are beyond the scope of this article; thus the focus is on short selling of shares. But the arguments for and against the practice are much the same, regardless of the asset class.

What is the difference between a “covered” and “naked” short?
A “covered short sale” involves the borrowing of shares for which no payment is made, followed by an immediate sale, and a subsequent purchase once the value of the shares has fallen, prior to the return of the shares to the original lender, together with a fee, the profit, if any, belonging to the short seller.

A “naked short sale” is a sale of shares the seller does not own and has not borrowed or made arrangements to borrow by the settlement date, but that the seller aims to buy before the settlement date, at a lower price, thereby making a profit.

Why does “naked” trading attract so much negative attention?
“Naked” short selling evokes strong sentiments for and against the practice and has ignited international concerns over the overall negative effects of short selling on global markets. Agreed, it can be purely speculative in the sense of a bet if the price declines. But often this type of short selling can be a useful mechanism to enforce market discipline and a legitimate tool with which to hedge but in order to hedge effectively, the purchaser must be making a compensatory hedge position, meaning he is long elsewhere. And that means the short is no longer in reality truly “naked”.

Traditional short selling is no different for the purpose of enforcing market discipline, as it prevents prices from reflecting only the most optimistic opinions about stocks. “Naked” shorting is often done by market makers as part of anticipatory inventory hedging, which is, in fact, not speculative at all.

Actions to address short selling issues
The criticism of short selling, particularly when in an uncovered or “naked” position, resulted in various reactions over the last two or so years during and following the financial crisis, as governments sought to restrict what they considered to be unacceptable speculative investment and to ensure market stability. But much of the action has been unilateral, without the consensus on any single policy and amidst opportunistic behaviour and political posturing.

In June 2009, the International Organisation of Securities Commissions (IOSCO) published its “Principles for the Effective Regulation of Short Selling”. The report recommended the introduction of appropriate controls to reduce risk, the introduction of a reporting regime providing timely data to market authorities, effective compliance and enforcement systems and the allowance for appropriate exceptions for certain types of transactions for efficient functioning and development of the market.

Individual countries and their regulators have however over the last two or so years introduced a variety of uncoordinated measures in an effort to stabilise their own local markets, for example:

  • the Australian Securities and Investment Commission (ASIC) implemented extensive measures and for a period introduced a total ban on short selling;
  • the Austrian Financial Regulator (FMA) banned “naked” short selling of the country’s four largest publicly listed financial service companies;
  • the German regulator (BAFin) introduced a ban on the “naked” short sales of Euro zone government bonds, unrelated CDS and shares of the top 10 German financial institutions inclusive of speculative trades. The ban was introduced in an attempt to prevent the further collapse of the Bourse, to shore up the Euro and to prevent contagion from within the EU. (The French supported the German cause but made it clear that they did not support a blanket ban, preferring to call in the European Commission to come up with its own proposals in an attempt to avoid member nations following divergent routes.);
  • the Greek regulator introduced a ban on the short selling of Greek financial stocks;
  • Italy imposed a short selling ban on the Borsa Italiana (but traders were still able to short Italian stocks on other European exchanges);
  • Japan’s Financial Services Association banned “naked” shorting in 2008 and regularly extends this ban;
  • the Spanish regulator (CNMV) required investors to notify it of any short positions exceeding 0.25 per cent of a company’s share capital and restricted “naked” short selling.

In the USA, during the financial crisis the SEC implemented various short term emergency bans on short selling of critical financial industry shares. In May 2010 (effective November 2010) the SEC introduced a new short sale-related circuit breaker, which if triggered, restricts the price at which shares can be sold short (effectively a reintroduction of the “uptick” rule abandoned in 2007).

Push back in some sectors
It is clear that there has been no unanimity in approach to date in relation to short selling.

The International Monetary Fund (IMF) published a report in fall 2010 stating that there was little evidence of the effectiveness of short sales bans, rather there was evidence that the ban decreased market liquidity and increased market volatility.

Finnish regulators criticised the move by BAFin, stating that all decisions should be cautiously made when markets are so nervous.

Stockholm registered its dissent during a lecture given by Stefan Ingves, Governor of the Swedish Central Bank, stating that due to the global status of financial markets, such regulation would be difficult to implement and administer.

London regulators (even though there was a temporary ban on short selling financial shares in 2008) did not agree that it was possible to introduce an effective short selling ban simply in one country, according to Douglas Webb, CFO of the London Stock Exchange Plc (LSE), and have recognised that “naked” short selling constitutes a legitimate part of market activity that helps to provide liquidity, when properly regulated. Andrew Baker, CEO of The Alternative Investment Managers Association (AIMA) voiced support of a Pan-European approach but argued that position disclosures should be made on an aggregated and anonymous basis, and opposed an entire ban on “naked” shorting.

Perhaps the best example of how unilateral action did not work was Germany’s ban on “naked” shorting. The country’s biggest bank, Deutsche Bank, continued the practice out of its London hub, where activity ceased for a few hours only, once BaFin admitted that its jurisdiction did not extend beyond German borders.

EU action
Within (Continental) Europe it was recognised at a political and bureaucratic level that a Pan-European approach to the perceived evil of short selling was required.

In early September 2010, Michel Barnier, the EU Commissioner for Internal Market and Services, announced that the newly formed watch dog, the European Securities and Markets Authority (ESMA), would come into operation in 2011, and would be able to ban abusive short selling of shares, “naked” selling of CDS and sovereign debt for three months or more, increase transparency levels on short positions and provide emergency powers for competent authorities.

On 15th September 2010 the EU Commission published the “The Proposed Short Selling Directive” (the Directive) that recommends that short positions in Euro shares should be notified privately to regulators once they amount to 0.2 per cent of a company’s issued share capital (and for each 0.1 per cent thereafter, public notification to the market should be made once they reach 0.5 per cent of issued share capital of the company). Transactions that threaten to cause adverse developments that may jeopardise the orderly conduct of the market will be banned such as those causing the share price of a single company to fall 10 per cent in a single day.

Restrictions will also be applied to selling of sovereign bonds and uncovered sovereign credit default swaps (CDS) of EU member states. Most importantly, as currently drafted, the Directive would effectively ban “naked” shorting. The Directive supersedes the proposed (but now deleted) provisions on shorting in the Alternative Investment Fund Managers Directive. It now passes to the European Parliament and the EU Council for negotiation and adoption, with a view to formal implementation by July 2012.

Reconciling a multilateral ban on “naked” short selling will not be without its problems. The US, the UK and the EU have very different views and approaches due to their differing systems.
To be effective, a ban on the “naked” short selling needs to be a Pan-European effort so as to deal with the alternatives available in London. Such European bans will remain largely ineffective should major financial countries such as the US and the UK not take comparable steps.

Further, banning “naked” short selling is a short-sighted solution as such trading is generally a symptom of an underlying problem and is not a cause in itself.

Whilst there may be some validity to the view that “naked” short selling of the type targeted for instance by the German regulators adds to volatility and may exaggerate pressure on the markets, temporary bans introduced without sufficient warning and in an uncontrolled manner can add to market volatility and drive investors out of the Euro zone for fear of what may follow.

Furthermore, a restriction on the ability to hedge exposure to Europe by “naked” short selling of European securities (including credit default swaps) may result in further concentrated selling of the Euro – not good news for European markets and its investors.

What may be of most concern is the opportunistic behaviour of many of the governments concerned, many of whom have acted without any compelling evidence against “naked” shorting, and often without real industry dialogue. The draining of the swamp may turn out not to be such a good idea after all.

Information correct as at 30 November 2010.