Overview of short sales
For a detailed overview see this entry in Wikipedia.
Sources of short interest data
Time delayed short interest data (for legally shorted shares) is available in a number of countries, including the US, the UK, Hong Kong and Spain.
Some market participants (like Data Explorers) believe that stock lending data provides a good proxy for short interest levels (excluding any naked short interest). The amount of stocks being shorted on a global basis has increased in recent years for various structural reasons (e.g. the growth of 130/30 type strategies, short or bear ETFs).
Major stock loan lenders
- State Street Corporation (Boston)
- JP Morgan Chase (New York)
- Northern Trust (Chicago)
- Fortis (Amsterdam)
- Citibank (New York)
- Bank of New York Mellon (New York)
- UBS AG (Zurich, Switzerland)
When a security is sold, the seller is contractually obliged to deliver it to the buyer. If a seller sells a security short without owning it first, the seller needs to borrow the security from a third party to fulfill its obligation. Otherwise, the seller will "fail to deliver," the transaction will not settle, and the seller may be subject to a claim from its counterparty.
Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as securities lending. The lender receives a fee for this service. Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.
Senator Kaufman urges more action on short sales
Source: A Level Playing Field for Investors Real Clear Markets, July 31, 2009
"First, the SEC should restore the substance of the uptick rule. This rule, a mainstay of investor protection for 70 years until it was repealed in June 2007, required investors simply to pause and to wait for an uptick in price before continuing to short sell. Without such a rule in place, investors who own stocks are more vulnerable to organized "bear raids" - abusive short selling combined with coordinated "misinformation" campaigns - which many believe contributed to the demise of Lehman Brothers and Bear Stearns, key elements in the collapse of our financial markets last year.
Second, the SEC should implement tougher rules that will stop naked short selling through an enforceable system. Naked short selling is the practice of selling stocks without first locating or borrowing the actual shares needed for timely delivery at settlement, sometimes in a concerted action to manipulate a stock price downward. This week, the SEC made permanent a temporary rule they had enacted last fall, proposed some new transparency measures, and announced plans for a Roundtable discussion on September 30.
That is some progress, but not enough. Two months from now, the Commission will finally begin to discuss publicly the potential solutions that I and a bipartisan group of Senators have been urging: either a pre-borrow requirement or a centralized "hard locate" system, which would prohibit short selling unless the executing broker first obtains evidence of a unique identifier number associated with specified shares set aside for timely delivery. The Depository Trust & Clearing Corporation tells us that it has the capacity and the willingness to implement that system - but only if the SEC requires it through a rule....
...Finally, the SEC should establish disclosure and transparency equality: the disclosure requirements that apply to pooled funds worth greater than $100 million should apply uniformly to all, including hedge funds, for both long and short positions. And the level of transparency for order flows should be the same for all."
US regulatory issues
SEC adopts new short selling rules
- Source: SEC Adopts New Short Selling Rules Alston & Bird, February 24, 2010
Today, the Securities and Exchange Commission (SEC) adopted new rules related to short selling. The new rule, an amendment to Rule 201 of Regulation SHO, will impose an "Alternative Uptick Circuit-Breaker" rule on short sales. Under this rule, if an equity security listed on a national market declines in price 10% or more in a day, a short sale may not be made at a price at or below the national best bid price for the rest of that trading day and the following trading day. Specifically, the new rule will require that trading centers establish and maintain a set of policies to reasonably likely to ensure that short sales in violation of the new amendments are not displayed or submitted to the national system.
- The SEC’s New Short Sale Rule: Implications and Ambiguities The Harvard Law School Forum on Corporate Governance and Financial Regulation, Annette L. Nazareth, Davis Polk & Wardwell LLP, March 14, 2010
SEC votes on uptick rule
Item 1: Amendments to Regulation SHO, Office: Division of Trading and Markets, Staff: Josephine Tao, Victoria Crane, Katrina Wilson, Angela Moudy
The Commission will consider whether to adopt amendments to Rules 201 and 200(g) of Regulation SHO relating to short sale restrictions. For further information, please contact Josephine Tao, Victoria Crane, Katrina Wilson, or Angela Moudy at (202) 551-5720.
- SEC expected to approve restrictions on short selling Washington Post, February 24, 2010
Former regulator says new rules "political"
- Source: SEC Let Politics Spur Short-Sale Decision, Sirri Says Bloomberg, March 30, 2010
The U.S. Securities and Exchange Commission’s decision to restrict short selling was a political decision rather than one based on evidence, according to a former agency official who says it may set a precedent for future decisions.
Commissioners who voted for curbs when a given stock falls 10 percent from the prior day’s closing price did so without proof that it would improve markets, said Erik Sirri, who ran the SEC’s division of trading and markets during the credit crisis that began in 2007.
The agency temporarily banned short sales on more than 900 financial stocks in September 2008. The Standard & Poor’s 500 Index went on to plunge more than 40 percent through March 2009. The SEC reintroduced limits on the practice last month that will be implemented later this year. The proposal followed more than 4,400 comment letters, most asking for restrictions on short selling, and Morgan Stanley Chairman John Mack blaming bearish bets for driving his company’s stock down in 2008.
“The SEC is going to have to decide how political it’s going to be,” Sirri, who ran the trading and markets unit from August 2006 until April 2009 as an appointee of Republican President George W. Bush, said at a conference yesterday. “It’s not exactly the case that short sellers were wrong” to bet against banks in 2008, he added. “Short sellers were making those prices more efficient. They were right.”
SEC holds securities lending and short sale roundtable
- The Securities and Exchange Commission today announced the panelists for its September 29 and September 30 roundtable in Washington D.C. to discuss securities lending and short sale issues, September, 25 2009
- Spotlight on Short Sales
- Notice of Roundtable Discussion; Request for Comment
- View comments
- Submit comments
- Source: SEC Holds Securities Lending Roundtable October 13, 2009, K&L Gates
By: Benoit N. Jacqmotte and Mark D. Perlow
On September 29 and 30, 2009, the Securities and Exchange Commission (SEC) held a roundtable on securities lending and short sales. On the first day, four panels of investor and industry representatives provided an overview of the securities lending market and discussed investor protection concerns, potential improvements to securities lending, and potential regulatory action in the area. On the second day, two panels addressed possible short sale pre-borrow requirements and additional short sale disclosure. This summary addresses the first-day roundtable on securities lending.
In a securities lending arrangement, the owner of securities lends out securities to market participants in exchange for a fee, upon posting of collateral (both of which, in the United States, usually take the form of cash). An institutional investor such as a mutual or pension fund will typically engage a custodial bank or other lending agent to handle the lending of securities to brokers and reinvestment of the collateral. Brokers borrow securities for a number of reasons, including for delivery of timely trade settlements and to lend to clients seeking to enter into short sales. In a short sale, a security is borrowed and sold in the market with the expectation that the security will be purchased later at a lower price (and returned to the lender), allowing the short seller to pocket the difference.
The commissioners and panelists generally agreed that securities lending is a critical component of proper market functioning because, among other reasons, such lending creates greater liquidity and enhances the ability to effect short sales (which in turn permit greater price discovery). With the intense scrutiny of short sales during the financial crisis and large losses suffered by certain institutional investors in their securities lending programs, the SEC has decided to shed light on and explore possible regulation in what SEC Chairman Mary Schapiro has called an “opaque” market.
Panel discussion focused on transaction price transparency, fee splits, cash reinvestment, proxy voting issues, the possible use of central counterparties and possible regulation. In general, while securities lending-related pricing information is available from various services, the price terms of loans tend to be individually negotiated between lending agents and brokers and depend in part on depth of information available to such parties. SEC staff members have previously expressed concern about the lack of transparency in both pricing and the supply of securities available for lending.
Net prices for borrowing securities are typically negotiated between parties and can range widely depending on such negotiations and market forces. For easy-to-borrow and highly liquid securities, lenders typically “rebate” to borrowers a substantial portion of the return they earn from reinvesting the cash collateral posted by a borrower. For hard-to-borrow securities, lenders can obtain a “negative rebate” from borrowers, in which borrowers must pay lenders a substantial rate of interest on the cash collateral for the right to borrow the relevant securities. This means that the effective cost of borrowing securities can range from a few basis points for easy-to-borrow securities to 20% and higher for hard-to-borrow securities.
Fee split arrangements between lenders and agents, under which an agent generally takes 10 to 50% of the net fees earned by a lender under its securities lending program, and the indemnification, termination and other provisions of these arrangements, appear to depend on the leverage and sophistication of the parties. Under these arrangements, securities lenders frequently delegate to their lending agents the task of reinvesting their cash collateral, usually pursuant to written guidelines in which the agent usually disclaims that it is acting as an investment adviser or manager. Given the fee splits between a lender and agent, an agent has an incentive to manage the reinvestment to yield the highest returns. Before the financial crisis, some agents reinvested securities lending cash collateral in instruments, for example in the securities of structured investment vehicles (or SIVs), that suffered from illiquidity and substantial losses during the financial crisis. Some lenders were unable to return collateral to borrowers who had returned loaned securities, and the decline in the value of these lenders’ cash collateral had to be marked to market, causing net asset value declines for these lenders.
These lenders, who had traditionally viewed the reinvestment of cash collateral as a low-risk business for a small reward, were caught flat-footed with substantial losses and liabilities. Some panelists suggested that such lenders placed undue reliance on their agents to make investment decisions or may not have fully understood the risks involved with these reinvestment programs. According to some panelists, while mutual funds tended to have the capacity and staff sophistication to “shop” among and negotiate these terms with different agents, other lenders, including smaller pension funds, did not have the capacity and expertise to negotiate in the same manner and may have been more susceptible to losses and liabilities under these arrangements. These panelists urged the SEC to consider requiring agents to make greater disclosures to all lenders regarding the range of instruments in which cash collateral may be reinvested and the risks inherent in such programs.
Panelists discussed the potential use of non-cash collateral in the securities lending process, noting that the posting of certain securities as collateral for the borrowing of securities is widely used in Europe. Some panelists suggested that the buildup of cash balances in securities lenders’ accounts caused volatility in lenders’ portfolios because the reinvestment of this collateral drove earnings during good economic periods and led to losses during bad periods. However, other panelists cautioned that while the use of other securities as collateral for securities lending (including short-term government debt securities) could mitigate some of these risks, the use of securities as collateral could introduce other risks, including correlation (or lack thereof) between the market risk of the collateral and that of underlying loaned securities.
Under securities lending arrangements, the borrower of securities generally becomes the record owner of the securities for proxy voting purposes if it owns the securities on the relevant record date. The interests of the short seller may not be aligned with those of the “long” holders of a company’s securities, including the lender: for instance, the short seller might want to vote against accepting a tender offer at a premium to the market price, since the offer would drive up the stock’s price and cause a loss in value in the seller’s short position.
Panelists discussed the record-keeping, conflicts of interests and other issues surrounding such proxy voting issues. Some panelists urged securities lenders to pay more attention to proxy voting to make sure they are able to maintain voting rights, by recalling loaned securities or otherwise, to give input on corporate action in line with their interests as “long” holders. Panelists representing both lenders and broker-dealers agreed that lenders appeared to face no difficulties or adverse consequences from recalling their loaned securities, such as being penalized by broker-dealers by losing future securities lending opportunities, and that lenders could address many of these issues by considering their proxy voting and related goals and adopting policies and procedures to give them effect.
Panelists also considered whether there should be central counterparties for securities lending, both to enhance price discovery for securities lending and to address counterparty risk. Several panelists asserted that, because price discovery was available to many lenders and their agents through pricing services, and since the collateral for borrowed securities was generally made in cash in an amount exceeding the price of the relevant security, the incremental value of using central counterparties would be minimal. Other panelists stated that the expanded use of central counterparties would have a positive impact on risk management and the transparency of the pricing and liquidity of securities lending.
Several panelists also urged the SEC to crack down on unregistered finders seeking to locate securities on behalf of broker-dealers for borrowing purposes, especially from retail owners of securities. According to these panelists, retail investors were particularly susceptible to misapprehending the risks, terms and consequences of lending securities in their portfolios. Richard Ketchum, chief executive of Financial Industry Regulatory Authority, stated that the organization is considering the adoption of rules designed to require broker-dealers to better disclose to their customers the risks and consequences of securities lending.
In her closing remarks, Chairman Schapiro stressed the SEC’s commitment to review the securities lending market’s benefits and pitfalls and to assess whether changes should be made in the regulation of the market. The SEC is accepting comments regarding issues addressed in the roundtable until October 30, 2009.
SEC seeking comment on alternative uptick rule
Washington, D.C., Aug. 17, 2009 — The Securities and Exchange Commission today announced that it is seeking public comment on an alternative approach to short selling price test restrictions that may be more effective and easier to implement than previously proposed price test restrictions currently under consideration.
The alternative uptick rule would allow short selling only at an increment above the national best bid. As a result, the Commission has determined to reopen the comment period for 30 days in order to receive input specifically on this alternative.
"Today's request for additional comment is consistent with the very deliberative process of determining what is in the best interest of investors," said SEC Chairman Mary Schapiro. "We want to ensure that everyone has a full opportunity to provide their comments on this alternative uptick rule before the Commission reaches any conclusions."
In April, the Commission proposed two approaches to restricting short selling. One approach would apply on a market-wide and permanent basis, and would implement short sale restrictions based on either the last sale price or the national best bid. The other approach, considered a "circuit-breaker," would apply only to a particular security during severe declines in the price of that security. Once triggered, the circuit breaker would impose a short sale halt or short sale restriction based on either the last sale price or the national best bid.
Unlike proposals in April, the alternative uptick rule would not require monitoring of the sequence of bids (that is, whether the current national best bid is above or below the previous national best bid), and as a result the alternative uptick rule would be easier to monitor. It also may be possible to implement this approach more quickly and with less cost than the prior proposals.
- Source: SEC Seeks Comment on Alternative Uptick Rule Proposal K&L Gates, August 19, 2009
- Source: SEC Takes Further Steps to Curtail "Naked" Short Selling; Short Sale Reporting Rule to Expire K&L Gates, July 30, 2009
On July 27, 2009, the U.S. Securities and Exchange Commission (the “SEC”) announced several steps designed to curtail short sale practices that it described as abusive and to increase market transparency.
First, the SEC made permanent, with minor modications, an interim final temporary rule (Rule 204T) that generally requires broker-dealers to promptly purchase or borrow securities to deliver on a short sale (the “Interim Rule”).
Second, the SEC announced that it would let expire temporary Rule 10a-3T, which requires institutional investment managers to make weekly filings describing their short sales and short positions; instead, the SEC will try to improve market transparency by working with its staff and several self-regulatory organizations (“SROs”) to make short sale volume and transaction data available via the SROs’ websites.
Third, the SEC announced its intention to host a public roundtable on September 30, 2009 to discuss a number of related topics, includings securities lending, pre-borrowing and possible additional short sale disclosures. Finally, the SEC stated that it is continuing to actively consider its recent proposals regarding short sale price tests (the “uptick rule”) and circuit breaker restrictions.
- Source: US to divulge detail on short-sellers FT Alphaville, July 28, 2009
"US regulators will in coming weeks release more detailed information on short-selling activity as they move to further boost transparency of trading. The SEC said on Monday that aggregate short-selling volumes in shares would be published on a daily basis while information about short-sale transactions in all publicly traded shares would be provided with a one-month delay."
SEC charges for "naked" short sales'
SEC Charges Options Traders and BDs for "Naked" Short Sales
The Securities and Exchange Commission today took its first enforcement actions for violations of the Commission's rules to prevent abusive "naked" short selling, charging two options traders and their broker-dealers with violating the locate and close-out requirements of Regulation SHO. The Commission also charged a supervisor at one of the firms.
Regulation SHO requires broker-dealers to locate a source of borrowable shares prior to selling short, and to deliver securities sold short by a specified date. The SEC alleges that the traders and their firms improperly claimed that they were entitled to an exception to the locate requirement, and engaged in transactions that created the appearance that they were complying with the close-out requirement. In fact, they were not entitled to the exception and were not complying with the close-out requirement.
Global overview of short sales regulation and enforcement
In the US, Regulation SHO was the SEC's first update to short selling restrictions since 1938. It established "locate" and "close-out" requirements for broker-dealers, in an effort to curb naked short selling.
Compliance with the regulation began on January 3, 2005. Source: Division of Market Regulation: Key Points About Regulation SHO, April 11, 2005
In the US, initial public offerings (IPOs) cannot be sold short for a month after they start trading. This mechanism is in place to ensure a degree of price stability during a company's initial trading period.
However, some brokerages that specialize in penny stocks (referred to colloquially as bucket shops) have used the lack of short selling during this month to pump and dump thinly traded IPOs. Canada and other countries do allow selling IPOs (including U.S. IPOs) short.
Short selling restrictions in 2008
In September 2008 short selling was seen as a contributing factor to undesirable market volatility and subsequently was prohibited by the SEC for 799 financial companies for three weeks in an effort to stabilize those companies. Source: SEC
At the same time the U.K. FSA prohibited short selling for 32 financial companies. Source: FSA
On September 22, Australia enacted even more extensive measures with a total ban of short selling. Source: NBR
Also on September 22, the Spanish market regulator, CNMV, required investors to notify it of any short positions in financial institutions, if they exceed 0.25% of a company's share capital. Source: Morningstar Naked shorting was also restricted.
In an interview with the Washington Post in late December 2008, U.S. Securities and Exchange Commission Chairman Christopher Cox said the decision to impose a three-week ban on short selling of financial company stocks was taken reluctantly, but that the view at the time, including from Treasury Secretary Henry M. Paulson and Federal Reserve chairman Ben S. Bernanke, was that "if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save."
Later he changed his mind and thought the ban unproductive.
In a December 2008 interview with Reuters, he explained that the Securities and Exchange Commission Office of Economic Analysis was still evaluating data from the temporary ban, and that preliminary findings point to several unintended market consequences and side effects. "While the actual effects of this temporary action will not be fully understood for many more months, if not years," he said, "knowing what we know now, I believe on balance the Commission would not do it again."
In the UK, the Financial Services Authority had a moratorium on short selling 29 leading financial stocks, effective from 2300 GMT, 19 September 2008 until 16 January 2009. Source: FSA clamps down on short-selling, 2008-09-18
After the ban was lifted, John McFall, chairman of the Treasury Select Committee, House of Commons of the United Kingdom, made clear in public statements and a letter to the FSA that he believed it ought to be extended.
In the US, a similar response was made by the Securities and Exchange Commission with a ban on short selling on 799 financial stocks from 19 September 2008 until 2 October 2008.
Greater penalties for naked shorting, by mandating delivery of stocks at clearing time, were also introduced. Some state governors have been urging state pension bodies to refrain from lending stock for shorting purposes. Source: Short Sellers Under Fire in U.S., U.K. After AIG Fall, 2008-09-19
The ban on short selling was further extended for another 28 days on 21 October 2008 Source: ASIC.gov.
Germany, Ireland, Switzerland and Canada banned short selling leading financial stocks, Source: NRE.com and France, the Netherlands and Belgium banned naked short selling leading financial stocks. Source: Forbes.com.
By contrast, Chinese regulators have responded by allowing short selling, along with a package of other market reforms. Source:  Reuters
An assessment of the effect of a ban on short-selling that was enacted in many countries in the fall of 2008 showed that it had only "little impact" on the movements of stocks, with stock prices moving in the same way as they would have moved anyhow, but the ban reduced volume and liquidity. Source: [author=Oakley D, Financial Times, 2008-12-18, page 27, "Short-selling ban has minimal effect"].
By December countries in Europe were considering to remove the ban, while the ban in the US was already lifted in October 2008. The SEC proposed new restrictions on short selling in April 2009.
EU considerations for a short selling regime
- Source: Commission public consultation on short selling - Eurosystem reply – European Central Bank, August 5, 2010
The Eurosystem welcomes the intention of the Commission to propose a EU harmonised regime on short selling practices. In general, recent episodes have shown the necessity of enhancing the level of transparency in the financial markets. When considering a possible EU regime on short selling practices, it is necessary to take into account the current state of the policy debate at international level, as only coordinated actions could be truly effective in particular in crisis situations.
- Measures Adopted by Competent Authorities on Short Selling ESMA, February 9, 2011
German short sale restrictions on CDS & financial firms
- Source: BaFin prohibits naked short-selling transactions and naked CDS in government bonds of euro zone BaFIN, May 19, 2010
The Federal Financial Supervisory Authority (BaFin) on Tuesday temporarily prohibited naked short sales of debt securities of euro zone countries admitted on a domestic exchange to trading on the regulated market. It also temporarily prohibited credit default swaps (CDS) in which the reference liability is at least also a liability of a euro zone country and is not used to hedge default risks (naked CDS).
Moreover, BaFin prohibited naked short-selling transactions in the shares of the following companies from the financial sector:
- AAREAL BANK AG
- ALLIANZ SE
- COMMERZBANK AG
- DEUTSCHE BANK AG
- DEUTSCHE BÖRSE AG
- DEUTSCHE POSTBANK AG
- GENERALI Deutschland HOLDING AG
- HANNOVER RÜCKVERSICHERUNG AG
- MLP AG
- MÜNCHENER RÜCKVERSICHERUNGS-GESELLSCHAFT AG
These prohibitions will apply from 19 May 2010, 00.00 hrs., to 31 March 2011, 24.00 hrs, and will be reviewed on an ongoing basis.
Contact for market participants: phone +49 228 4108 - 4004.
Proposal for pan-European short-selling disclosure regime
- Source: New Regulatory Approaches to Short Selling in the U.S. and the EU K&L Gates, March 12, 2010
CESR Proposals. On March 2, 2010, CESR published a final report outlining its proposed model for a pan-European short selling disclosure regime (the "Report"). The Report follows CESR's July 2009 short selling consultation (for more information please refer to our July 2009 client alert).
The short selling regime proposed in the Report is a two-tier model for the disclosure of significant individual net short positions in all shares that are admitted to trading on a European Economic Area (“EEA”)-regulated market and/or an EEA multilateral trading facility, when the primary market of those shares is located in the EEA. This relates to the whole market rather than just one particular sector (e.g., financial sector companies), as CESR is of the opinion that "the risks posed by short selling are not confined to the financial sector and it is not possible to predict with any certainty how the next crisis might develop or which sector might become vulnerable to abusive short selling or disorderly markets."
Under the proposed regime, a short seller would be required to make:
a private disclosure to the relevant regulator of any net short position in a company's issued share capital that reaches a threshold of 0.2% of the issuer company's issued share capital. Any increases or decreases of 0.1% above the 0.2% threshold would trigger further disclosure obligations, meaning that, for example, notifications would need to be made to the relevant regulator at 0.3% and 0.4% and so on; and a public disclosure to the market as a whole as well as to the relevant regulator once the short seller's net short position reaches 0.5%, and at every 0.1% above that (for both increases and decreases). Disclosures would include the identity of the short position holder, the identity of the issuer, the size of the position held, and the date on which the position was either created or no longer held.
In calculating whether a disclosure is required, market participants will be required to aggregate any position providing them with an economic exposure to a particular share. Positions held in exchange-traded and OTC derivatives will be included, as will short positions in cash markets. Disclosure calculations and reports are to be required on a net basis, with any positions involving long economic exposures to a share deducted from aggregate short positions. Disclosure reports of short positions (to the market and/or to the regulator) will be required to be made on the trading day following the day on which the relevant threshold has been crossed. CESR recognizes that intra-day positions that breach a disclosure threshold, but that return below that same threshold before the end of the trading day, will not be captured. Market makers will be exempt from the disclosure requirements.
Anticipated Developments. CESR comments in the Report that it is continuing to work on a number of outstanding issues, such as the mechanism of reporting and the content of disclosure reports that must be made. CESR will publish its determinations as soon as it is able.
CESR also comments in the Report that, although the design of a common disclosure regime has been prioritized so far, CESR is continuing to consider whether further harmonized measures for the regulation of short selling, beyond disclosure, are required and feasible. CESR does consider that enhanced transparency has real, justifiable benefits and, accordingly, has decided to prioritize development of a pan-European disclosure regime.
Implementation. CESR states in the Report that CESR members that already have powers to introduce a permanent disclosure regime will now begin the process of implementing the regime. Those CESR members that do not have the necessary legal powers to bring new rules into force in their jurisdiction are expected to aim toward implementing it on a best efforts basis. CESR also expresses its support for a new EU directive or regulation to give all EEA securities regulators explicit stand-alone power to require disclosure in respect of short selling.
CESR recognizes that individual CESR members may need to impose temporary emergency measures (such as bans or partial bans or the imposition of special conditions on short selling). CESR is currently examining whether all its members have the necessary powers to introduce such measures and, if not, what steps may be required to remedy any deficiencies.
We set out below the position in Germany and the UK. We also comment on the Greek Prime Minister’s recent comments on short selling and related matters.
Germany. On March 4, 2010, the German Federal Financial Supervisory Authority, Bundesanstalt für Finanzdienstleistungsaufsicht ("BaFin"), issued a general decree loosely based on the CESR proposal, which requires that market participants and holders of net short positions in any of 10 selected financial stocks (primarily banks) must make disclosure to BaFin when the net short position reaches, exceeds or falls below a threshold of 0.2% of the issued share capital of that company and every 0.1% thereafter. BaFin has also announced that it will publish (in an anonymous format) all short positions that reach or exceed 0.5%.
For German purposes, the "net short position" definition generally follows the CESR recommendations referred to above and, also in conformity with CESR, there is an exemption from the disclosure requirements for market makers. BaFin's new rules come into force on March 25, 2010 and will initially apply up to and including January 31, 2011.
In addition to the BaFin disclosure requirements, the German Ministry of Finance has also recently announced that it will propose legislation in April to ban naked short selling. The Ministry of Finance intends to create a statutory framework for regulatory transparency rules covering all shares traded on a regulated market and to provide for effective sanctions to ensure that such reporting requirements can be enforced.
UK. The current UK Financial Services Authority ("FSA") rules require that disclosure must be made to a regulatory information service in the UK by 3:30 p.m. (UK time) on the business day following the date on which a disclosable short position is reached or exceeded. A disclosable short position is any net short position in one of a defined list of UK financial services companies where the position reaches, exceeds or falls below 0.25% of the issued share capital of the company and each 0.1% threshold thereafter (i.e., the net short position reaches 0.35%, 0.45%, and so on).
The FSA has not yet published any comment on when or how it will amend its current short selling rules to reflect the position advocated by CESR. The FSA's current rules were brought into force on June 30, 2009, as a temporary regime to cover short selling in the UK until such time as consensus was reached on a wider international short selling regime.
In addition, the UK's draft Financial Services Bill would, if implemented as it is currently drafted, provide the FSA with much wider powers to make rules to prohibit or require disclosure of short selling. The proposals would also permit the FSA to make rules relating to short sales engaged in before any new rules are made but where a short position remains open when the rules come into force.
Greece. The Greek Prime Minister George Papandreou, who recently met with President Obama and Secretary of State Hillary Clinton regarding the crisis in Greece, has said that he wants to see the U.S. and the rest of the G-20 develop "clear rules on shorts, naked shorts and credit default swaps," as he believes that many hedge funds have bet against Greece's ability to repay its debts. Despite the Greek Prime Minister's aspirations for wider regulation, Anastassios Gabrielides, chairman of Greece's Capital Market Commission (and chairman of the CESR committee that prepared the Report), said: "The regime [proposed by CESR] would help to identify and restrain potentially abusive behavior at an early stage and allow regulators to take timely preventive measures. While private notifications to the regulators would be used for daily market supervision activities, public disclosure of short positions is considered to provide informational benefits to the market." It is not yet clear whether, or in what manner, Greece proposes to implement the CESR proposals.
Industry Reaction. Andrew Baker, the chief executive officer of UK's Alternative Investment Management Association ("AIMA"), stated that he agrees with CESR that consistent rules for short selling throughout the EU are required, saying that consistent rules for short selling throughout the EU were "desirable" and were preferable to banning the practice (as happened in the UK in September 2008 in relation to certain financial stocks). However, he has also called for improvements to the proposed CESR reporting regime. In AIMA's view, any reporting of short positions should be in aggregate form only, and disclosure of individual positions should only be made privately to the regulator to prevent potentially serious market distortions. AIMA’s view is that the 0.2% (private) and 0.5% (public) disclosure thresholds are too low.
The MFA has expressed support for the general approach taken in Germany by BaFin but has registered concern regarding the lack of detail in the reporting requirements and the potential additional costs that could be shouldered by investors.
- Harmonized European Short Selling Disclosure Regime Proposed The Harvard Law School Forum on Corporate Governance and Financial Regulation, April 3, 2010
CESR's update on short selling September, 2010
- Source:Measures adopted by CESR Members on short selling - Updated - CESR, September 1, 2010
The document is an update of the actions by exchanges and regulators by countries in the EU related to short selling practices.
CESR's view of short selling during the crisis
- Source: Markets Participants Consultative Panel (MPCP) Committee of European Securities Regulators, 24 June 2009, CESR premises, Paris
Agenda item 3| Short selling
Short selling remains a hot topic among financial market participants. The MPCP Chair underscored the fact that in this field, regulatory measures continue to be heterogeneous across European countries and that after nine months of discussion there is still no common position – except a general agreement on more transparency whose specifics are however controversial. Some jurisdictions have lifted their bans, others are currently reviewing them, and still others have prolonged or adapted their prohibitions. Current areas of investigation and analysis by regulators are mainly naked short-selling, settlement cycles and settlement failures.
The message of the MPCP members on short selling was very clear (see also the documents in annex 1 and 2):
- by prohibiting short sales, regulatory authorities have given a strong signal that short selling is a technique of market abuse and as such detrimental to markets, whereas it rather is an irreplaceable hedging technique;
- as result of the bans, investors left the market;
- after the ban, it became clear that the decline in bank stocks was due to the general market
perception not to short sellers;
- tightened regulation concerning market abuse should be sufficient to deal with many potential
problems linked to short selling;
- the best way to deal with problems linked to naked short selling is by heavily sanctioning
settlement failures – though this might not be enough, a prohibition could be considered;
- short and well as long positions should be disclosed to regulators (but not to the market, which should be informed about not more than the hedges of long positions if at all) on a frequent basis so that they are sufficiently informed in extreme situations – one member argued that, with respect to naked short sales, transparency should be market-wide;
- MAD should be enough to deal with many issues, except when the one of orderly markets is
- regulatory coordination is needed: any measure with respect to short selling needs to be carried out in an equivalent form across borders.
It is likely that within the new EU financial architecture, measures like those relating to short selling would have to be taken at national level, and only in exceptional circumstances at the level of the Authority.
FSA sets out policy on short selling
- Source:FSA sets out policy on short selling FSA, Octobe1, 2009
The Financial Services Authority (FSA) has today issued a Feedback Statement that confirms that it intends to pursue enhanced transparency of short selling through disclosure of significant short positions in all equities. However, it will work towards agreement on future requirements at an international level rather than introducing a separate domestic regime. In the meantime it has no plans for immediate changes to its current short selling requirements.
Currently, the FSA requires disclosure to the market of net short positions of 0.25% or more of the issued share capital of UK financial sector companies or companies carrying out a rights issue.
Alexander Justham, FSA director of markets, said:
"The consultation exercise has confirmed our support for enhanced disclosure requirements for significant short positions rather than any direct restrictions on short selling, other than on a temporary basis in exceptional market conditions. But we remain committed to securing agreement on as wide an international basis as possible and, in particular, to achieving a harmonised regime within Europe."
The Feedback Statement details the responses that the FSA received to its proposals in the February 2009 Discussion Paper (DP) on short selling. The DP examined the arguments for and against restrictions on short selling. It proposed a disclosure requirement for the short selling of all stocks, not just those of financial services companies, using an initial disclosure threshold of 0.5% of issued share capital. It also stated that the FSA’s preferred route was to achieve international agreement on policy.
Since the DP was published the Committee of European Securities Regulators (CESR) has issued proposals for a short selling disclosure regime. CESR’s proposals for public disclosures of significant short positions are very similar to the FSA’s but also include the idea for private disclosures to regulators at 0.1%. In today’s Feedback Statement, the FSA states that it is open to the possibility of requiring private disclosures at the lower threshold. The FSA will continue to work with CESR to develop an agreed European disclosure policy for short selling.
- Source: Comment Letter for the Consultation paper on CESR Proposal for a Pan-European Short Selling Disclosure Regime, CFA Institute, September 29, 2009
"We are broadly supportive of CESR’s effort at convergence in this area. The wave of short selling bans that took place in autumn 2008 throughout the EU not only showed a lack of coordination between EU securities regulators, but most importantly posed a concrete threat to the functioning of the internal market. That experience still stands today as the most powerful argument in favour of the creation of a robust and legitimate EU short selling regime.
In order to achieve this, we feel that more resources should be devoted to the development of an agreed definition of the object of the regulation. We refer in particular to “aggressive short selling”.
is in fact difficult to provide concrete evidence, as explicitly requested by CESR during the Open Hearing held on 9th September, on a new pan-European regulation that would find its main rationale in the prevention of a phenomenon that has not, so far, been described thoroughly and that lacks an agreed definition.
Another crucial area where more needs to be done is the assessment of the costs involved in the different policy options. The data received by market participants can potentially be biased, and may either overestimate or underestimate the costs of a new regulation. As a consequence, we urge CESR and in particular the authorities part of the Short Selling Task Force to independently define the impact of what it is being proposed.
Finally, we believe that a comprehensive short selling regime should address crucial issues such as bans, post-trade disclosure, settlement, and in particular naked short selling. We look forward to receiving more information on the next steps.
For what concerns the preliminary suggestions made by CESR, we are aware of the additional implementation costs posed by the flagging option. However, we believe that, in parallel with the introduction of a consolidated tape, flagging can bring greater benefits and avoid some of the problems connected with disclosure and market abuse.
As for the individual public disclosure to the market we strongly believe that disclosure should be anonymous, in order not to deter short sellers from what is a legitimate and useful investment strategy. Moreover, we are also convinced that short sales data should be published in aggregated form. This is why we do not agree with the system proposed by CESR as it stands in this proposal.
Australia releases guidance on short selling obligations
- Source: 10-86AD ASIC releases guidance on short selling obligations Australian Securities and Investment Corporation, April 23, 2010
ASIC has today released regulatory guidance to assist with compliance with new legal requirements under the Corporations Act 2001 and Corporations Regulations 2001 in relation to short selling.
ASIC’s guidance is contained in a revised version of Regulatory Guide Short selling 196 (RG 196), which was first published in September 2008 as Regulatory Guide 196 Short selling: Overview of s1020B.
The revised RG 196 clarifies the legal position about what short sales are permitted, as well as specific reporting and disclosure obligations.
It contains an overview of short selling concepts and new provisions in the Corporations Act as a result of the changes to the legislation about short selling, and various relief that ASIC has granted in relation to some of these provisions, in certain circumstances.
Importantly, RG 196 outlines the two types of reporting obligations (i.e. reporting of short sale transactions and of short positions), as well as an exemption from reporting short positions below a certain threshold (contained in ASIC Class Order [CO 10/135] Relief for small short positions). It also clarifies ASIC’s policy for granting relief to allow naked short selling in some circumstances. ASIC has reviewed the exemptions over time in regards to liquidity in the market.
A copy of RG 196 is available from the ASIC website at www.asic.gov.au/shortselling.
ASIC also encourages short sellers and system developers to continue to monitor ASIC Information Sheet 98 Short selling: Short position reporting (INFO 98), which includes key tasks and practical information they must be aware of prior to the start date for the new reporting requirements.
Background In September 2008, ASIC took emergency action to temporarily ban short selling in Australia, including naked short sales and covered short sales. The ban on covered short selling of non-financial securities was lifted on 19 November 2008. The ban on covered short selling of financial securities was lifted on 25 May 2009.
The Federal Government introduced new legislative requirements to regulate the use of short selling in Australia in December 2008 and December 2009, under the Corporations Amendment (Short selling) Act 2008 and the Corporations Amendment Regulations 2009 (No. 8). These requirements include a ban on naked short selling, subject to some minor exceptions, and the imposition of specific reporting obligations in relation to covered short sales. The legislation that commenced in December 2008 also clarified the scope of ASIC’s powers in relation to the short selling provisions in the Corporations Act.
Australia releases draft regs for short sales
- Source: Short Selling Disclosure Regulations, Minister for Financial Services, Superannuation and Corporate Law, October 2, 2009
The Minister for Financial Services, Superannuation and Corporate Law, Chris Bowen MP, today released draft regulations and commentary material in relation to the disclosure of short selling information under the Corporations Amendment (Short Selling) Act 2008.
The draft regulations require:
the reporting of covered short selling transactions to market operators. This information will be aggregated and publicly released by market operators on the following business day. This is consistent with the existing Australian Securities and Investments Commission's (ASIC) interim disclosure regime; and the reporting of short positions by short sellers to ASIC. This information will be aggregated by ASIC and released to the public four business days after the positions are taken. The reporting of short positions will commence on 1 April 2010. These draft regulations have been developed following both public consultation and targeted consultation with key stakeholders.
"The regulations strike the right balance between the market's interest in knowing what short selling is occurring and the legitimate interests of businesses in not having their trading strategies compromised," Mr Bowen said.
"This disclosure timetable was finalised following close consultation with the corporate regulator and industry, and was determined to be the most liberal approach that was consistent with maintaining market integrity.
"This regime will give people the first complete overview of short selling in Australia.
"The regulations will finalise the Government's enhancement of the regulatory regime governing short selling, which also included banning naked short selling and providing ASIC with enhanced powers in relation to short selling activity."
The Government has completed its consideration of the policy issues associated with the regulations but is seeking comments from stakeholders on a range of technical issues (outlined in the commentary material) by 23 October 2009 with a view to having the regulations considered by the Executive Council in November 2009.
The Government will review these regulatory arrangements 12 months after the commencement of the new positional reporting requirements.
The draft regulations and related commentary material can be downloaded at www.treasury.gov.au.
- Corporations Amendment Regulations 2009 (No. )1 Select Legislative Instrument 2009, Draft Short Selling Disclosure Regulations
Singapore Exchange proposes short sale rule
- Source: Singapore Exchange Proposes Short Sales Report to Increase Market Transparency Asiatrading, July 23, 2010
To facilitate greater market transparency, Singapore Exchange (“SGX”) is proposing new rules and measures to provide more information on short sales activities in the marketplace. SGX is seeking public comments on the proposed rules that require the marking of all sell orders, either as a normal sell order or a short sell order. With the collated data, SGX proposes to report the short sales volume and value by counter for each trading day.
Timely short selling information provides greater disclosure and contributes to enhanced accountability. SGX regards greater transparency as beneficial to market participants.
This consultation exercise is introduced after close discussions with the Monetary Authority of Singapore (“MAS”) following SGX’s public consultation in November 2008 on transparency measures in relation to short-selling. The MAS is fully supportive of the proposed measures, and views them as a positive step towards increasing the transparency of short selling activities in our market.
U.S. firms oppose rules to curb short selling
- Source: U.S. firms oppose rules to curb short selling, September 29, 2009, Reuters
Goldman Sachs Group Inc <GS.N> and Vanguard Group Inc are among U.S. companies opposed to rules proposed by U.S. regulators to limit short selling, according to letters filed by the companies.
The U.S. Securities and Exchange Commission had asked for comments on a proposal to reinstate the “uptick” rule, under which investors can short a stock only after it had moved higher.
In a short sale, an investor sells borrowed stock in anticipation of a price decline that will allow him to repurchase the shares at a lower price.
Some lawmakers and financial industry executives say short selling has worsened the financial crisis and driven down share prices. [ID:nN174026]
Goldman and Vanguard were among several companies and exchange operators opposing new restrictions on short sales.
“[T]he available empirical data suggest that short selling may benefit the market by exposing financial misconduct and aligning market prices with fundamental analysis,” Paul Russo, Goldman’s head of U.S. equity trading, wrote in a comment latter to the SEC.
Other investors, including T.Rowe Price, submitted letters expressing support for the new rules.
“[W]e believe appropriate short selling serves a valid purpose and can enhance liquidity and price discovery,” T.Rowe Price said in a letter signed by Michael Gitlin, head of global trading. “However, short selling has also been utilized as a device to manipulate stock prices in an abusive manner and has negatively impacted investor confidence.”
Did naked shorts bring down Bear and Lehman?
- Source: Wall Street's Naked Swindle Rolling Stone (Matt Taibbi), October 14, 2009
"On Tuesday, March 11th, 2008, somebody — nobody knows who — made one of the craziest bets Wall Street has ever seen. The mystery figure spent $1.7 million on a series of options, gambling that shares in the venerable investment bank Bear Stearns would lose more than half their value in nine days or less. It was madness — "like buying 1.7 million lottery tickets," according to one financial analyst.
But what's even crazier is that the bet paid.
At the close of business that afternoon, Bear Stearns was trading at $62.97. At that point, whoever made the gamble owned the right to sell huge bundles of Bear stock, at $30 and $25, on or before March 20th. In order for the bet to pay, Bear would have to fall harder and faster than any Wall Street brokerage in history.
The very next day, March 12th, Bear went into free fall. By the end of the week, the firm had lost virtually all of its cash and was clinging to promises of state aid; by the weekend, it was being knocked to its knees by the Fed and the Treasury, and forced at the barrel of a shotgun to sell itself to JPMorgan Chase (which had been given $29 billion in public money to marry its hunchbacked new bride) at the humiliating price of … $2 a share. Whoever bought those options on March 11th woke up on the morning of March 17th having made 159 times his money, or roughly $270 million. This trader was either the luckiest guy in the world, the smartest son of a bitch ever or…
Or what? That this was a brazen case of insider manipulation was so obvious that even Sen. Chris Dodd, chairman of the pillow-soft-touch Senate Banking Committee, couldn't help but remark on it a few weeks later, when questioning Christopher Cox, the then-chief of the Securities and Exchange Commission. "I would hope that you're looking at this," Dodd said. "This kind of spike must have triggered some sort of bells and whistles at the SEC. This goes beyond rumors."
Cox nodded sternly and promised, yes, he would look into it. What actually happened is another matter. Although the SEC issued more than 50 subpoenas to Wall Street firms, it has yet to identify the mysterious trader who somehow seemed to know in advance that one of the five largest investment banks in America was going to completely tank in a matter of days. "I've seen the SEC send agents overseas in a simple insider-trading case to investigate profits of maybe $2,000," says Brent Baker, a former senior counsel for the commission. "But they did nothing to stop this."
The SEC's halfhearted oversight didn't go unnoticed by the market. Six months after Bear was eaten by predators, virtually the same scenario repeated itself in the case of Lehman Brothers — another top-five investment bank that in September 2008 was vaporized in an obvious case of market manipulation. From there, the financial crisis was on, and the global economy went into full-blown crater mode.
Like all the great merchants of the bubble economy, Bear and Lehman were leveraged to the hilt and vulnerable to collapse. Many of the methods that outsiders used to knock them over were mostly legal: Credit markers were pulled, rumors were spread through the media, and legitimate short-sellers pressured the stock price down. But when Bear and Lehman made their final leap off the cliff of history, both undeniably got a push — especially in the form of a flat-out counterfeiting scheme called naked short-selling..."
Naked short sale defination
A naked short sale occurs when a security is sold short without borrowing the security within a set time, 3 days (T+3)in the US. This means that the buyer of such a short is buying a counterfeit share, a share that was not issued by the company or nothing at all.
This is possible because the stock market has dematerialized - shares are mere entries in a computer. Because of this, naked shorting has been made illegal except where allowed under limited circumstances by market makers. It is supposed to be detected by the Depository Trust & Clearing Corporation (in the US) as a "failure to deliver" or simply "fail".
While many fails are settled in a short time, some have been allowed to linger in the system. Systemic abuse such as turning over short positions to avoid T+3 detection is possible. Naked shorting is generally used in a manipulative fashion such as a bear raid to bring down a stock. Victims of bear raids often report that more shares turn up to vote at an AGM (annual general meeting) than were issued by the company.
In the US, making arrangements to borrow a security before a short sale is called a locate. In 2005, to prevent widespread failure to deliver securities, the Securities and Exchange Commission (SEC) put in place Regulation SHO, intended to prevent investors from selling some stocks short before doing a locate. More stringent requirements were put in place in September 2008, to prevent the practice from exacerbating market declines. The efficacy of these measures are under review in 2009.
When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service, usually a standard commission similar to that of purchasing a similar security.
If the short position begins to move against the holder of the short position (i.e., the price of the security begins to rise), money will be removed from the holder's cash balance and moved to his or her margin balance. If short shares continue to rise in price, and the holder does not have sufficient funds in the cash account to cover the position, the holder will begin to borrow on margin for this purpose, thereby accruing margin interest charges. These are computed and charged just as for any other margin debit.
When a security's ex-dividend date passes, the dividend is deducted from the shortholder's account and paid to the person from whom the stock was borrowed.
For some brokers, the short seller may not earn interest on the proceeds of the short sale or use it to reduce outstanding margin debt. These brokers may not pass this benefit on to the retail client unless the client is very large. This means an individual short-selling $1000 of stock will lose the interest to be earned on the $1000 cash balance in his or her account.
Futures and options contracts
When trading futures contracts, being 'short' means having the legal obligation to deliver something at the expiration of the contract, although the holder of the short position may alternately buy back the contract prior to expiration instead of making delivery. Short futures transactions are often used by producers of a commodity to fix the future price of goods they have not yet produced. Shorting a futures contract is sometimes also used by those holding the underlying asset (i.e. those with a long position) as a temporary hedge against price declines. Shorting futures may also be used for speculative trades, in which case the investor is looking to profit from any decline in the price of the futures contract prior to expiration.
An investor can also purchase a put option, giving that investor the right (but not the obligation) to sell the underlying asset (such as shares of stock) at a fixed price. In the event of a market decline, the option holder may exercise these put options, obliging the counterparty to buy the underlying asset at the agreed upon (or "strike") price, which would then be higher than the current quoted spot price of the asset.
Selling short on the currency markets is different from selling short on the stock markets. Currencies are traded in pairs, each currency being priced in terms of another, so there is no possibility for any single currency to get to zero. In this way selling short on the currency markets is identical to selling long on stocks.
Novice traders or stock traders can be confused by the failure to recognize and understand this point: a contract is always long in terms of one medium and short another.
When the exchange rate has changed, the trader buys the first currency again; this time he gets more of it, and pays back the loan. Since he got more money than he had borrowed initially, he makes money. Of course, the reverse can also occur.
An example of this is as follows: Let us say a trader wants to trade with the dollar and the Indian rupee currencies. Assume that the current market rate is $1 to Rs.50 and the trader borrows Rs.100. With this, he buys $2. If the next day, the conversion rate becomes $1 to Rs.51, then the trader sells his $2 and gets Rs.102. He returns Rs.100 and keeps the Rs.2 profit.
One may also take a short position in a currency using futures or options; the preceding method is used to bet on the spot price, which is more directly analogous to selling a stock short.
Note: this section does not apply to currency markets.
It is important to note that buying shares (called "going long") has a very different risk profile from selling short. In the former case, losses are limited (the price can only go down to zero) but gains are unlimited (there is no limit, in theory, on how high the price can go).
In short selling, this is reversed, meaning the possible gains are limited (the stock can only go down to a price of zero), and the seller can lose more than the original value of the share, with, in theory, no upper limit. For this reason, short selling is usually used as part of a hedge rather than as an investment in its own right.
Many short sellers place a "stop loss order" with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.
The risk of large potential losses through short selling inspired financier Daniel Drew to warn:
"He who sells what isn't his'n, must buy it back or go to pris'n"
Short selling is sometimes referred to as a "negative income investment strategy" because there is no potential for dividend income or interest income. One's return is strictly from capital gains.
Short sellers must be aware of the potential for a short squeeze. When the price of a stock rises significantly, some people who are shorting the stock will cover their positions to limit their losses (this may occur in an automated way if the short sellers had stop-loss orders in place with their brokers); others may be forced to close their position to meet a margin call; others may be forced to cover, subject to the terms under which they borrowed the stock, if the person who lent the stock wishes to sell and take a profit.
Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments. Short interest is defined as the total number of shares that have been legally sold short, but not yet covered.
On occasion, a short squeeze is deliberately induced. This can happen when a large investor (a company or a wealthy individual) notices significant short positions, and buys many shares, with the intent of selling the position at a profit to the short sellers who will be panicked by the initial uptick or who are forced to cover their short positions in order to avoid margin calls.
Short sellers have to deliver the securities to their broker eventually. At that point they will need money to buy them, so there is a credit risk for the broker. To reduce this, the short seller has to keep a margin with the broker.
Short sellers tend to temper overvaluation by selling into exuberance. Likewise, short sellers are said to provide price support by buying when negative sentiment is exacerbated after a significant price decline. Short selling can have negative implications if it causes a premature or unjustified share price collapse when the fear of cancellation due to bankruptcy becomes contagious. Source: The Theory and Practice of Short Selling
Finally, short sellers must remember that they are going against the overall upward direction of the market. This, combined with interest costs, can make it unattractive to keep a short position open for a long duration - unless naked shorters have been creating a significant number of counterfeit shares.
Short sellers are sometimes regarded with suspicion because, in the views of some people, they are profiting from the misfortune of others. Source: Samantha Bee Daily Show Reportage on Short Selling, March 16, 2009
Occasionally businesses campaign against short sellers who target them, even resulting in litigation.
Short sellers (legal and illegal) exacerbate volatility to the downside and as we saw in 2008, may result in failures and even though such failures are the direct result of underlying problems, the crashing of share price brings its own set of problems such as lenders responding by cutting off credit. Such problems were so severe, many countries banned short selling in the critical financial sector for many months.
Since all or most shorts start off as naked shorts (though not illegal until T+3), and the detection of naked shorts through fails is somewhat cumbersome, it can be said that legal shorting 'covers' naked shorting, ie if no shorting were allowed, naked shorting would be much harder.
Naked shorts create counterfeit or fictitious shares. Legal shorting (called covered shorting in Australia) creates a situation that, while technically not creating a duplicate, has a duplicatory quality in that two owners have interest in the shares. Any increase in the number of shares (supply) normally tends to depress the price thus making shorting a self fulfilling strategy. Cramer has pointed out that the playing field is not level in that shorters can duplicate/create shares at will whereas companies must go through a lengthy process to create or even buy their own shares.
Lack of transparency permeates the system. Many share owners are not aware their shares are being loaned out by their fund managers. Short data is not released until two weeks later (on average). Fails data is only released quarterly. Market data such as market capitalization of a company, a key metric, is not adjusted to reflect short or fails information.
The system is biased toward shorting due to the tremendous commissions generated by shorters, hedge funds and others. To get an idea of the volume of shorts, consider that hedge funds hedge (balance long with short positions) and comprise about 1/4 of the entire industry (by asset value) and trade more actively than say pension funds. In addition, regulators in this sector have a particularly close relationship with those they regulate, there being a two-way flow of personnel.
Rebuttal of criticism
Advocates of short sellers say that the practice is an 'essential' part of the price discovery mechanism. Source:Short Sale Constraints And Stock Returns by C.M Jones and O.A. Lamont
How essential is open to debate since it was apparently not essential during the 8 month ban. They state that short-seller scrutiny of companies' finances has led to the discovery of instances of fraud which were glossed over or ignored by investors who had held the companies' stock long. This argument leads one to question the usefulness of the regulator.
Some hedge funds and short sellers claimed that the accounting of Enron and Tyco International was suspicious months before their respective financial scandals emerged.
Financial researchers at Duke University have provided statistically significant support for the assertion that short interest is an indicator of poor future stock performance (the self fulfilling aspect) and that short sellers exploit market mistakes about firms' fundamentals. Source: Do Short Sellers Convey Information About Changes in Fundamentals or Risk?
Such noted investors as Seth Klarman and Warren Buffett have said that short sellers help the market. Klarman argued that short sellers are a useful counterweight to the widespread bullishness on Wall Street, Margin of safety (1991), by Seth Klarman.
While Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies. Source: 2006 Berkshire Hathaway Annual Meeting Q&A with Warren Buffett
In response to the UK and US moves to ban short selling in September 18 and 19 of 2008, UBS set out a good example of the financial industry's position: "This can be characterized as a populist reaction of no positive value. Anyone who seriously thinks that the cause of this crisis arises from the actions of evil and manipulative speculators lacks the insight and knowledge to be allowed anywhere near the regulation of financial markets. Short selling may well exacerbate problems, but it was not the cause. (UBS Investment research's daily roundup). Source: Investment bankers of the world, unite!, 2008-09-19.
UBS expanded its opinion stating that the banning of short selling is a "policy error" that created problems, referring to the Organisation for Economic Co-operation and Development bans of 2008. Source: Be afraid. Be very afraid, Daily roundup for 2008-10-31.
Despite reassurances given above, it is apparent that the public is increasingly concerned about shorting. Cramer has started a petition calling for the reintroduction of the uptick rule Source: The Street.com signed by 5691 (Source CNBC.com) people who understand what the uptick rule is (shorters, industry participants).
Other online petitions exist, one calling for outright abolition of shorting and another calling for a modified system to serialize and track shares. These can be found at a site called petitiononline com which has been blacklisted by wikipedia and therefore cannot be referenced properly. Add the following to the url: /shortNOT/petition.html and /mrktrfrm/petition.html respectively. That these petitions have fewer signatures should not be taken as evidence of lesser support given the almost complete lack of understanding among the public about this entire subject.
- Short-selling bans in the crisis: A misguided policy Voxeu.com, February 6, 2010
- SEC to consider new short sale curbs next week Reuters, February 20, 2010
- Short-sale disclosure will jack up costs, sap liquidity, warns hedge fund group Investment News, February 9, 2010
- Short Changed? The Market's Reaction to the Short Sale Ban of 2008 Bank of Canada Working Paper 2009-23, August, 2009
- Short Selling to Hedge Risk from Market Making Activities, Australian Securities and Investments Commission, April 2009
- Porsche VW Shortselling Scandal
- "Short-Selling Bans Dampen 130/30 Strategies Worldwide," Global Investment Technology, Sept. 29, 2008
- Market Beat
- Seeking Alpha
- Data Explorers
- Short Stories
- How to Identify Short Squeezes
- Short Selling Introduction
- Short Interest: What it tells us
- SEC Discussion of Naked Short Selling
- '"Financial Interest Disclosures Can Protect Markets From 'Short & Distort' Manipulators", Alex J. Pollock, June 6 2006, Washington Legal Foundation
- Coverage of controversial short-selling 'conspiracy' lawsuits by tobacco litigation specialists in US: Short Tempers, Risk Magazine (2006), Navroz Patel
- Don't Sell Short Selling Short
- High Short Interest