Alan Kohler
The blind leading the naked
A long/short hedge fund and a long-only fund joined up yesterday to attack the Australian government’s ban on short selling as too restrictive and pointless, but they both had to admit that securities lending was under-regulated, and not transparent enough.
Tim McGowan of hedge fund Fortitude Capital came to the forum organised by Riskmetrics, an institutional proxy advisor, with lots of graphs to show that stock lending, and therefore short selling, does not usually result in companies’ share prices falling. Most of the time the real cause is “long-only” selling done for good reason.
Andrew Sisson of long-only manager Balanced Equity Management argued that for every short sale, the seller has to buy back the shares and on the whole he agreed that short selling receives too much blame for falling share prices.
Helen Nugent, the chair of Funds SA, was the third member of the panel, representing major super funds. She steered clear of the debate about the government’s ban on short selling, perhaps because she is also a director of Macquarie Bank, and argued that super funds and their custodians were not paying enough attention to the risks associated with stock lending, in particular operational and collateral risk.
As moderator of the panel, I asked Tim McGowan how often borrowed stock is recalled so the deal can be re-priced (because the stock on the market has moved). The answer was “hardly ever”. (I actually think it is never.)
That means that while share prices rise and fall on the market, once a stock is lent, normal pricing mechanisms go into suspended animation.
Andrew Sisson agreed that price discovery in securities lending is dysfunctional because it operates as a one-to-one, over the counter market – that is, prices are not set by an open transparent marketplace.
And Helen Nugent said that funds that lend stock are not getting paid enough for the risks they are taking, which she says is partly a function of the quality of their custodians.
I asked Tim and Andrew how can they say short selling is a good thing and is operating well to provide liquidity in the stockmarket while at the same time admitting that securities lending is dysfunctional and needs to be regulated properly. It’s true that not all borrowed stock is sold short, but nearly all of it is, and Tim agreed that there is virtually no naked short selling (where the stock is not borrowed first).
There was no clear answer to this. Securities lending, it was agreed, needs to be regulated and disclosed; short selling, on the other hand, is a good thing and disclosing it without also reporting the buy-backs on the other side of the trade, as currently occurs, is misleading. Confusion reigns.
Meanwhile the German financial regulator, Bafin, added to the confusion last night by announcing an extension of its ban on short selling of 11 financial companies until May 31.
This was reported by both the Wall Street Journal and Reuters as an extension of Germany’s ban on “naked short selling” of those 11 banks, although that term was not used by Bafin in its announcement. Looking at the fine print of German’s definitions, though, that does seem to be accurate: naked short selling of 11 banks is banned.
So apparently you can sell all the other stocks in Germany and fail to deliver them at settlement. And after the end of May you’ll be able to do that with the banks as well.
The German stockmarket seems to be functioning normally. The Dax 30 index was down a pretty solid 5.1 per cent last night, but since the beginning of last year it has fallen by exactly the same percentage as the MSCI world index (46 per cent).
But frankly the German position is bizarre and illogical, and further evidence that global regulation of short selling is an absolute mess. That is, you apparently don’t have to deliver sold stock at settlement in Germany – just shrug your shoulders and say: “Sorry, that sale was short. I don’t have it.” That simply cannot be true. Without enforceable settlement a market could not function.
For that reason, naked short selling is banned everywhere. In Australia Credit Suisse was recently fined for failing to settle. Covered short selling, where the stock delivered at settlement is borrowed, has a wide range of treatments by regulators but, as agreed by Tim McGowan and Andrew Sisson, it is not properly disclosed.
The G20 leaders meeting in London this week should send their regulators off with fleas in their ears to fix this up.
Do you have to own what you sell? Can you borrow it and then sell it? If so, who gets the vote and the dividend? And what should be disclosed, and to whom? How should the price of the stock securities loan be set? Who should get the proceeds of it?
And who should do the lending – the funds, the custodians or the managers? They are all acting as agents for the ultimate owners of the shares and are borrowing and lending stock like mad for their own purposes, not in the interests of the owners.
It is a disgrace that securities regulators have not sorted this out yet.
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