Earlier this week, Australia joined the US, the UK, France, Germany, Canada and other countries in clamping down on the practice of “short selling” shares. According to the regulator, the Australian Securities and Investments Commision (ASIC), the new restrictions were aimed at reducing “unwarranted price fluctuations”. For the moment, the restrictions are in place for a period of 30 days, at which point ASIC will decide whether to extend or lift the restrictions.
For many outside the financial markets, the practice of short selling is a mysterious one and, for some, rather worse than that. The following letter to the editor in the Sydney Morning Herald is a case in point:
Short selling can be carried out only if the buyer is misled into believing that the seller owns the stock (“ASIC in total ban on short selling“, September 22). Can short selling ever be morally justified? Surely the only beneficiaries of such activity are those with sufficient funds to manipulate the sharemarket. After all, we cannot legally “short sell” anything else we do not own, such as a neighbour’s house, business or car.
Laurie Mangan Tamworth (September 23)
So what is short selling? Contrary to Laurie’s view, there is no misleading involved but it does involve selling shares that, essentially, you do not own. There are two types of short selling: naked (which really sounds naughty) and covered (which sounds a bit better). To explain what each of these involves, I’ll first go into some of the mechanics of share trading.
When you buy or sell shares, there is a “settlement period”, which means that while I might agree today to buy or sell some shares today, money and shares do not change hands today. In Australia, the standard settlement period is three business days, which means that any share trades I might have done today (Thursday) would not settle until Tuesday. So, if I bought shares, I would have until Tuesday to find the money. Likewise, if I sold shares I would have until Tuesday to find them. The reason for this three day settlement period is to allow time to deal with the fiddly operational side of share transactions: account transfers, registry instructions and so on. It’s just like a shorter version of the typical six week settlement period (in Australia) for sales of residential property, only shorter.
With that in mind, naked short selling is simply selling shares you do not own. This gives you three days to come up with the shares or “fail” to deliver shares on the settlement date. The simplest form of naked short selling involves buying the shares back later the same day. In this case, you can match the share transfers for the buy and the sell in three days time. The alternative, which is somewhat more complicated, is to vary the settlement period. Just as people buying a house will request an extended settlement period because they have not yet sold their current property (and so they do not have the money yet to buy the new house…remind you of anything?), so you may be able to negotiate an extended settlement period for a short sale of stock, which will give you more time in which to buy it back.
If all of that sounds a bit hard and fraught with danger, it is. For that reason, even before the recent restrictions were introduced, naked short selling in Australia was very restricted: only an approved list of market participants were allowed to use this technique. Covered selling was a far more common approach to short selling. In this case, before you sell shares, you “borrow” them from someone who already owns the shares. Now why would anyone lend me shares? Because I will, in exchange, lend them money, typically at a low rate of interest. So, I might borrow $100 worth of shares (or, more likely, a bit more than that) and in return lend $100 in cash. Later, I will return the shares and get my money back, plus some interest (let’s say 10 cents, to keep things concrete). While that is the idea, in practice the whole transaction is done by means of a “repurchase agreement” (or “repo”). What this means is that you actually sell the shares to me for $100, but at the same time we agree that I will sell you those shares back in, say, a week for $100.10 (regardless of what they are actually worth then). Effectively, you lend me the shares and I lend you $100 and you pay me $0.10 in interest, but in practice I am now the legal owner of the shares, so I can very easily sell them (no misleading the buyer there!). All I have to do is buy them back within a week’s time to return them to you. Up until Monday this week this was not only perfectly legal, but quite commonplace.
While there are those who argue that it is unethical to sell shares you do not own, it is hard to make this argument consistently unless you are also going to condemn the practice of borrowing to buy a house: after all you are giving the vendor money you do not really own! Although this is exactly not far from the position that proponents of Sharia law would adopt, condemning much home mortgage lending as usury.
But why would anyone indulge in the nefarious practice of short selling? One reason is for hedging risks. For example, option traders will use shares to offset the risks of options they have bought or sold. Of course, the other reason is simply because you think that the share price is going to drop: you sell at the current price and buy back later at a lower price and pocket the difference. I deliberately said “you think that the share prices is going to drop” as opposed to “you want to push the share price down”. A single market participant is unlikely to be able to sell enough shares to have a big enough impact on the share price to force prices down very far for long. But if a lot of investors think that a particular stock is over-valued and start short-selling, that is a different matter.
Short-selling is a popular practice for the dreaded “hedge funds”. Some people take a dim view of hedge funds, seeing them as dastardly speculators who are forcing down share prices to the detriment of “ordinary” investors. This perspective misses a few key points:
- Most hedge funds are “long/short” funds, so they take as many “long” positions (buying shares) as short positions, so even if they were big enough to significantly move prices, they would be pushing some share prices up and others down.
- Where does most of the money invested in Australian hedge funds come from? Superannuation funds. So, most of the profit hedge funds make from short-selling is in fact going to “ordinary investors”.
- Who has been the biggest beneficiary of the new restrictions? Not ordinary investors, but the “millionaire’s factory”, Macquarie Bank. Despite being one of the biggest short-sellers in the market themselves, they were the focus of attention of short-sellers last week and apparently spent last weekend lobbying for the introduction of a ban in the hope that it would prop up their own share price.
- Both financial theory and research (see, for example, “Which Shorts Are Informed?”) suggest that short-sellers help make markets more “efficient” in the sense that overpriced stocks are corrected earlier, reducing the size of the price fall that would eventually occur in a market in which short-selling was prohibited.
In ASIC’s defence, these are extraordinary times in global financial markets and some form of regulatory response was unavoidable and, so far at least, since the introduction of the ban the volatility of the Australian market has decreased. While some would argue that Australia should have followed the UK example and limited the restrictions to the short-selling of financial institutions, probably the most important consideration in this kind of environment is transparency. There was a lot of confusion in the markets on Monday as people tried to come to grips with the scope and implications of the changes. For now various parts of the market are in limbo: securities lending, contracts for difference (“CFDs”) and long/short funds, which can maintain current positions but cannot put on new positions. Furthermore, there is no guarantee that the intial boost that the short-selling ban brought to the market will last; the details of the US bailout plan are starting to get fiddly and US share prices have begun to fall. It may turn out that all Macquarie’s efforts were in vain…options are still legal, so maybe it’s time to buy some puts!
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Yes options might still be legal but does the options market still exist? How are they being priced in markets where proper hedging cannot take place? As real options?
@killinc: There is an exemption on covered short-selling for approved options market-makers, so the options market does still exist. I imagine it is limping badly though, as I expect that they are finding it harder to borrow stock that it would have been a week ago.
Whatever one’s thoughts on the ethics or othrwise of short selling, the law of unintended consequences (very fashionable right now!) is going full throttle. Liquidity is lower, brokerage fees are lower due to this lower velocity of trading, transaction costs are higher…..the finance industry is a hair’s bredth away from significant job losses, to the point where I’ll have to go learn a trade! There is a danger now that there is nobody to buy into a sharp equity sell-off (ie. short coverers). Buy and holders won’t be dominant enough in aggregate to hold off an unsuccessful US bailout. We could be turning very ugly here.
As usual, a very concise and clear explanation Sean. However, I have
to object to the statement that “this is exactly the position that proponents
of Sharia law would adopt”. While for separate reasons that are too intricate
to explain here, Sharia law would proscribe most forms of short-selling,
there is nothing in Sharia against borrowing money to buy a home, nor against
lending for such a purpose. The feature of lending which is proscribed under
Sharia is the charging of fixed interest on such loans (or at least, excessive
fixed interest, depending on whose interpretation of Sharia law you take).
If the lender accepts no interest, or makes an arrangement under which
she shares the risk of principal and interest being repaid, then it is all legal
under Sharia law.
@Mark: Your point is well taken: my reference to Sharia law was too brief to capture their approach correctly.
As I understand the restrictions you describe, and I am certainly no expert on Sharia law, if a lender advances 70% of the purchase price of a house then they assume 70% of the risk, benefiting is the house price rises and losing if it falls. I would argue in this case that effectively this is a joint purchase despite being labelled a loan. In a way it is the opposite of a repo which is structured as a sale but is effectively a (collateralised) loan. It is interesting to note that the Sharia restrictions would prevent the excess of leverage in mortgage markets and elsewhere that are at the root of the current financial crisis!
In any event, I’ve edited the post to be (a little) less simplistic.
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