ASIC has gone further than other regulators in banning short selling in all stocks not just financials. ASIC released a statement on Sunday (21 September 2008) banning all covered short selling in all stocks (subject to limited authorised market-maker exception). This ban is to be re-assessed after 30 days with possible rollback permitting covered short sales in non-financial stocks.
This action follows on from an ASIC release last Friday where the following 3 measures were implemented:
1. Banned all naked short selling.
2. Clarify, and in so doing, narrow the permitted class of covered short selling.
3. Introduce reporting regime for permitted covered short sales.
Today, the ASX open was delayed 1 hour due to some confusion about how the ban would affect the hedging of existing positions. ASIC issued a statement effectively saying the ban does not require current short positions to be unwound or closed but rather prohibits any new or increase in net short positions. However, it is still unclear whether new short positions as part of hedging arrangements can be entered into, presumably this would be allowed for market-makers under the exemption mentioned.
Why has ASIC gone further than FSA & SEC?
Tony D'Aloisio, of ASIC, stated: "These measures are necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets. Because of the relatively small size and the structure of the Australian market, it is necessary to extend the prohibition to all stocks. To limit the prohibition to financial stocks, as has been done in the UK, could subject our other stocks to unwarranted attack given the unknown amount of global money which may be looking for short sell plays".
Further, ASIC emphasised that it sees a legitimate place for short selling in markets (e.g. to assist with price discovery). Mr D'Aloisio went onto say: "However, in the current climate and, in light of the actions taken by other regulators, we need a circuit breaker to assist in maintaining and restoring confidence. Our measures do that as they will operate for a limited time and in the case of non-financial stocks, will be reviewed in 30 days. In the case of financial stocks, the review will be in line with the time limits imposed by other international regulators such as the US and UK".
Immediate Reaction
Predictably once trading opened the market rallied around 4%. Banning short-selling might result in a quick rally, but will it be sustained or solve the underlying problem? The rally will be more the result of false confidence and a "short squeeze" rather than fundamentals where those with existing shorts (i.e. apparently only hedge funds!?) will be forced to buy-back stock to close out their positions and limit or avoid losses.
Solvency
With three statements in three days from ASIC it appears to be a quick and crude attempt to bandaid the prevailing market conditions. The fact remains that the current solvency situation still exists and is due to a number of factors not least the failure by Regulators to oversee complex financial products and the abusive application of leverage on company balance sheets. Initiating this emergency action could indeed lead to more uncertainty and panic as evidenced by the opening of the ASX.
Liquidity, Price Discovery & Market Efficiency
Banning short-selling will ultimately reduce the liquidity, price discovery and efficiency of the market. While some may argue the effect of a reduction in liquidity will by minimal & outweighed by an anticipated reduction in volatility it is also good to remember that volatility is often associated with illiquid markets so you want to get the balance right. Additionally rather than adding volatility, historically short selling tends to smooth out price fluctuations.
Derivatives
Liquidity will also be reduced by the knock-on effect from the derivatives market where participants (other than the exempted market makers) will not be able to hedge their derivatives exposure (i.e. options or futures) by taking positions in the underlying market. Shorting is a widely used and legitimate tool in derivatives strategies to hedge risk (e.g. delta hedging).
Further, the ability to take short positions in CFDs is effectively stopped as CFD providers will be unable to hedge their clients' CFD positions in the underlying market. In the case of DMA (Direct Market Access) providers the stoppage of shorting will be immediate as these providers hedge via straight through processing into the underlying market. It is also likely the stoppage will be implemented by Market Makers as most hedge their clients? CFD positions on an aggregate basis.
Transparency
The ASX currently provides a daily list of what percentage of a company's stock is short-sold - it cannot be greater than 10% as per market rules. However, for full transparency short sales should be marked as such at the time of trade (e.g. just as cross trades are). Further it would be interesting and informative to see what percentage of daily turnover is actually attributable to short-sellers. Transparency is the key in averting a situation where fear overtakes, however unpopularly it may also reveal that the scapegoat (i.e. short selling and by proxy hedge funds) is simply just that - a scapegoat.
Hedge Funds
There is media speculation this could be the ruin of the industry. The short answer is No. The affect on hedge funds will most notably be in the area of equity-based strategies and particularly, market neutral, long/short, 130/30, convertible arbitrage, and dedicated short. With approximately 57% of hedge funds in Australia employing equity-based strategies the effect on performance could be noticeable over the next month. Some funds may choose to sit on the sidelines, reduce exposure or perhaps even unwind their positions (both long and short) so while the stock price of some companies might benefit others won't.
It is important for all to heed the gravity argument that "whatever goes up must come down" - maybe those in financial markets should rediscover this gem and get more in touch with their physical assets rather than those paper assets!
