MONDAY’S SURPRISE decision by Britain’s Financial Services Authority (FSA) to lift the ban on the short-selling of financial shares has catalysed renewed debate on the efficacy of such restrictions.
The British action follows a similar move by Taiwan’s financial regulator last week, who said that short-selling is “not as horrible as some of our legislators seem to think”.
European regulators, however, disagree – anti-shorting measures in Germany, France and Belgium were extended in the week before Christmas and German restrictions are now in place until March 31st.
The Irish ban remains in place for the foreseeable future.
Short-sellers borrow stock in a company and sell it in the hope of buying it back at a lower price later, thereby allowing them to profit from a declining market. The strategy came under attack during the financial panic in September, with jurisdictions across the globe banning or restricting the activity amid fears that it might further imperil an already fragile financial system.
Alexander Justham, head of markets at the FSA, denied that the decision to lift the ban by January 17th was an admission that it had failed in its attempt to calm markets. “It certainly played its role in dealing with that difficult situation in the back end of last year,” Mr Justham said. The FSA said it was prepared to “reintroduce the ban without consultation if necessary”.
American regulators think otherwise, however. The US ban on shorting of financial stocks lasted just three weeks and was allowed lapse in early October. Even that was too long for Christopher Cox, the embattled head of the US Securities and Exchange Commission (SEC).
Mr Cox said recently that agreeing to the temporary ban was the biggest mistake of his tenure and that he was pressurised into acting by Treasury secretary Hank Paulson and Federal Reserve chairman Ben Bernanke, both of whom were “of the view that if we did not act and act at that instant, these financial institutions could fail as a result”.
New academic papers confirm Mr Cox’s reservations. Prof Ian Marsh and Norman Niemer of the Cass Business School in London looked at the daily returns of UK, US, French, German and Italian shares before and after the imposition of restrictions. They found “no strong evidence that these have been effective in reducing share price volatility or limiting share price falls”.
A US study led by Columbia professor Charles Jones was more unequivocal, charging that the ban caused a “severe degradation in market quality, as measured by spreads, price impacts, and intraday volatility”.
Countless papers have found that “shorting restrictions cause prices to be wrong”, the study notes, so this was entirely predictable in advance.
The study found that the ban led to a strong initial price pop but artificial price gains could not be sustained and financial stocks ended up falling by more than the 30 per cent decline experienced by the market as a whole during the three-week ban.
In Ireland, short-selling remains banned to “ensure the orderly conduct of the market”. However, it has failed to stem the bleeding in Irish financial stocks, which were decimated in the months following the ban.
Despite the academic findings and Mr Cox’s mea culpa, short-sellers continue to attract widespread opprobrium.
David Cumming, head of UK equities at Standard Life Investments, last month called for the ban to be extended on the grounds that shorting was potentially “destabilising”, with some hedge funds acting like “financial terrorists”.
In Ireland, accusations of financial terrorism have also been levelled, especially after Anglo-Irish Bank’s share price was hammered in the aftermath of Bear Stearns’s collapse last March.
In the US, many are calling for a return of the “up-tick rule”, which previously prevented shorts from initiating positions in free-falling stocks.
Shorts deny the terrorist charge, arguing that their warnings of trouble in the financial sector have proved prescient. Indeed, the ban on short-selling has not prevented Anglo’s collapse and last March’s low of €6.15 must look tempting to those who are now holding on to a penny stock.
The Irish ban, according to the Financial Regulator, is under “continuous review”.
European regulators recently recommended a “convergent” approach to the matter.
Academics caution that continued tinkering is doomed to fail. “Future observers will look back at this shorting ban with the same kind of wonder that economists reserve for Nixonian price controls and other similar government interventions”, say the authors of the Columbia study.
“Those future observers will probably ask: did they really think that would do any good?”
