Here we go again: short selling in the firing line

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by Greg Bright

In 2008, with the global financial crisis gathering pace, a handful of countries, including Australia, banned short selling. This was later admitted by regulators, such as the Hong Kong Monetary Authority and the UK’s former FSA, to have been a mistake. Hedge fund managers, and a few other groups, were at the fore in showing how stock lending and shorting improved market efficiency in such times. They may need to do so again.

It’s almost as incomprehensible as the panic stock piling of toilet paper, one prominent fund manager said last week, of bans on short selling. To prevent the market’s natural response to any situation – good or bad – questions the efficacy of a market.

It may be the role of elected governments to legislate to inhibit market activity – a political decision reflecting, hopefully, the majority of society’s views. But for pluralist, democratic, capitalist countries, such as Australia and New Zealand and more than half the western world, it is difficult to justify handing a sledgehammer to a regulator.

Michael Gallagher, the general manager and a director of AIMA Australia, the alternatives investments body which went into bat in 2008 to have the short-selling ban lifted, said there were “always murmurings” about short selling in times of high market volatility. So far, only Italy, Spain, France, Greece, Belgium and Austria have banned short selling for the time being, although the European Securities and Monetary Authority (ESMA) publicly supported their moves.

Closer to home, and more importantly, UniSuper, the $85 billion industry fund for the Australian tertiary education sector, surprised its peers by suspending its stock lending program, administered by its custodian BNP Paribas Securities Services, and recalling all shares that were out on loan, “without exception”, according to a statement from the fund.

John Pearce, the highly regarded UniSuper CIO, as is the fund itself, having won numerous industry awards, said: “The ability to short-sell adds to liquidity and price discovery in an orderly market. However, we are now in a market gripped by panic and we believe that restricting the ability to short sell is in the best interest of promoting a more orderly market. We are only one fund and the efficacy of our actions will depend on how many other funds follow a similar path. Of course, we are not privy to the thinking of other funds who lend their stock.” As of last week, UniSuper is the only big fund to have announced such action, which doesn’t mean other funds have not acted similarly without going public on it.

Many disagree with the sentiment. Some fund managers, in particular, believe that the value in price discovery through the ability to short stocks outweighs the costs of restricting trading. “Price discovery is where people balance off the risks,” according to Jim Savage. He was the senior sales and marketing person at Tribeca Investment Partners in 2008 and worked closely with Sean Fenton, who ran the firm’s “alpha extension” long/short fund.

Savage recalls coming into the office early the Monday morning (September 21, 2008) after ASIC made its announcement. This followed announcements in the UK and US the previous Friday, for bans on shorting financial stocks. “Fenton was already there, and he said to me: ‘did you see they’ve banned all short selling?’. I said: ‘no, it’s just on financials.’ He handed me a copy of the Australian announcement. I was shocked.”

But not only did Australia go much further than other countries with its ban, the Australian ban also lasted much longer, Savage points out. The UK lifted its ban in January 2009, followed by the US, but Australia did not do so until May that year.

Sean Fenton, who last year launched a boutique, Sage Capital, said last week that the current conditions represented a “great unknown”. He said: “Volatility is through the roof and in that environment hedge funds cut back their growth exposures. They buy back their shorts and sell the risk.”

He believes that there is a “ticking clock” there in terms of structural unemployment and small businesses going to the wall. It’s a major economic risk. Markets are dysfunctional right now because there is so much uncertainty. Otherwise-stable companies, which may have a bit of debt, are getting knocked over, he says.

In a bad month for the share market, Sage Capital’s absolute returns fund, which has no equity exposure, is up 10 per cent in the month to date. Its long/short fund is also doing well, Fenton says.

Michael Gallagher says that, like the current cause of the latest example of market panic itself, these things – meaning short-selling bans or restrictions – have a habit of becoming contagious. Last week, the Philippines went one further than Spain and Italy by ceasing all trading on the Philippines exchange indefinitely.

To that end AIMA Australia has been working with the association’s global headquarters in London to produce an updated paper on the crucial contribution that short selling makes to not only the share market efficiency for its investors, but to the efficiency of the whole of the capital markets. Gallagher was hopeful the paper would be distributed soon.

Gallagher said: “AIMA has continued to highlight publicly and privately our concern that restricting short selling is an unhelpful response that restricts price formation at a crucial time for hedgers and investors. ESMA has also put in place more onerous reporting requirements for short positions and we are pressing at senior level within ESMA the need for a clear statement that late reporting won’t lead to fines.

“More generally, AIMA’s view is that regulators should be looking to ease operational burdens on firms so that they can continue to trade and serve their investors.  London is following up with various European authorities individually to press this point… You might also have seen press commentary about the potential for market closures. Our position on this is clear: restricting trading at this time is unwarranted and has the potential to trigger fire sales in other markets and disrupt hedging. Our engagement with individual regulators suggests that they understand the damage that poorly coordinated action could cause.”

This time, for Australian investors, the regulators seem more relaxed than in 2008. There were subsequent ‘permanent’ restrictions imposed back then, that the market has learned to live with. Kim Ivey, a long-time hedge fund manager and one of the founders of AIMA in Australia, said: “ASIC has far better insight into the degree of real short selling through the reporting mechanisms they put in place post the GFC.”

He said last week: “What one finds is much more targeted short-selling positions than what the public is speculating on: hordes of short sellers indiscriminately targeting banks, insurance companies and REITs in huge volume. The evidence is just not there that this is occurring. It is obviously liquidation from traditional long-only managers and their institutional investors doing the selling.”

ASIC instituted not only a requirement for more disclosure, showing more of the ‘short interest’ in a stock, but also the ‘uptick rule’, which means that shorts can’t go lower than the market ‘offer’ price. Clearly, the latter requirement is not ideal as it can be manipulated by market participants.

Ivey, now working with a start-up boutique soon to launch a global macro strategy, Albany Capital, believes that ASIC has already “tapped on the brakes” with brokers, just last week, to curtail their order flow. “This is crazy,” he said.

However, word on the street last week was that ASIC is also concerned about the liquidity aspects of any drying up of securities lending and/or shorting programs. The word is that ASIC has been asking custodians and funds about withdrawals of such programs in order to ensure that there is liquidity for March-end derivatives rollovers and index re-balancing.

Coupled with potential market closures, any short-selling restrictions were unwarranted, Ivey said. “Our position on this is clear: restricting trading at this time is unwarranted and has the potential to trigger fire sales in other markets and disrupt hedging.”

Paul Chadwick, a founder and chair of ESG-orientated manager Nanuk Asset Management, which has a long/short fund running alongside its mainstream global equities fund, and who is a director of the global board for AIMA, said: “It’s an old chestnut and, in my view, has limited relevance here as it has had throughout history. The current situation arose from equity markets being stupendously expensive on all the unfashionable but robust valuation metrics (Schiller CAPE, Tobin’s Q etc.) and hence super vulnerable to a downside shock.

“The [Coronavirus] happened to be that catalyst and the rest is history. Fear and greed are at work. Greed got us up there and fear is bringing us down. I don’t know the stats on the shorts in play, but I find it hard to believe that they’ve had a material impact on or been the cause of these really big market moves which seem to be characterised by panic-induced across-the-board selling.”

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