To stop short-selling, stop lending stock
No companies complained when speculators pushed shares higher in a rising stockmarket, but now markets have turned it is fashionable to condemn short-sellers – typically hedge funds - for making weak markets weaker. The regulators at the Financial Services Authority have bent to fashion by forcing short-sellers to reveal their positions in companies making rights issues.
But if ever there was a case for self-regulation, surely this is it. Short-sellers can operate only by borrowing stock from City institutions: if the pension funds and insurance companies refused to lend, shorting would end.
Most investment involves long positions - buying shares with a plan to sell when the price has risen. Short-selling is when an investor sells shares it does not own with the intention of buying them after the price has fallen. There is as much scope for short-sellers reading the market wrongly and losing money as there is with conventional investment, but short-sellers need to borrow stock to cover their position.
They borrow from the institutions that hold most of the shares in quoted companies, paying them a small fee. But the loss on the underlying stock borrowed will far exceed the fee if the short-seller has got it right.
Just as a long investor’s buying tends to push up a share price making the sought-after gain self-fulfilling, the short-seller’s selling tends to help the price fall the investor is seeking. But revelation of short positions will undermine sentiment further.
If the institutions stopped lending stock to short-sellers the problem would be solved. They would lose their fee but the value of their holdings would not be pushed down. And because the same institutions also earn fees sub-underwriting rights issues, refusing to lend would make it less likely they would be forced to take up unwanted rights.
So why do the institutions keep lending? Because if one fund held back others might continue supplying stock, leaving the abstainer without a fee but with a loss on its holding? Or because hedge funds are not the only short-sellers: many institutions are happy to ‘sell’ while keeping their stock to offset the losses on the retained holding.
July 2nd, 2008 at 11:13 am
I am Chief Executive of the International Securities Lending Association, which represents more than one hundred beneficial owners, their agents and borrowers of securities in Europe. As you might expect, we do not believe that stopping securities lending would benefit institutional investors. They would lose the lending income, market liquidity would fall and, in all likelihood, the effect on the value of the investments over any meaningful period from the perspective of a long-term investor would be zero.
Short selling has often been made the scapegoat for price falls but, on calmer analysis, has rarely been found to be the underlying cause. Those who argue that short sellers can drive a share price below its fair value need to explain why other investors do not take that buying opportunity. There are many more potential buyers of shares than short sellers. The best way to get a fair price for shares is to allow all market participants, with their varying views, to trade in them. Putting obstacles in the way of those that believe share prices are over-valued will only make prices less efficient. Investors will be more likely to buy shares at inflated prices.
More importantly, restricting securities lending would do wider damage than inconveniencing short sellers. Only a fraction of securities borrowing is to cover short sales by investors with a simple directional view that a share price will fall. More commonly, securities are borrowed to prevent settlement fails; or to enable arbitrage: for example, to go short individual shares versus an index-based basket, such as a futures contract; or by dealers to hedge positions taken when providing liquidity to their clients by purchasing their shares.
The one certain consequence of reduced securities lending would be less liquidity and higher trading costs for investors.
To read more about ISLA and ISLA’s views on this subject please visit http://www.isla.co.uk.
July 4th, 2008 at 11:09 pm
I’ve got a good idea. When looking for reasons for aggressive share price moves to the downside, why don’t we start with the companies and more importantly the executives running these companies.
Lets take good old Bradford and Bingley. An utterly rubbish management team who basically followed the herd in the housing market, never made any strategic decisions to even begin to call the top of the housing market and in fact just lent money wlly nilly to anyone who walked through the door. Then, when they were basically going bust, pledged to have better financial controls within the company !!!
It doesn’t take a genius to work out why the share price went down fast. As for those idiot institutional investors left holding the shares, they also deserve everything coming their way. They shouldn’t be holding the shares to lend in the first place !!!! Its always the same lot. Standard Life, Legal & general, etc. Always left holding the baby and always complaining about short sellers.
Short selling is an absolute irrelevance. Management teams are paid to run companies and know their industries. None of them have.
Fund Managers are paid to perform and sell bad companies and buy good ones. Very few of them have. Imagine if the Executive team at Bradford & Bingley came out last year and made a public strategic decision to stop lending, conserve cash and dispose of the mortgages. God forbid, they might even have hedged their liabilities. They would now be the last man standing and could be making bottom of the market acquisitions rather than begging Americans for money.
Why is this so difficult ?