ASIC has announced that it will lift the ban on short selling of non-financial stocks from 19 November 2008 to coincide with a new reporting regime for short sales.
The new arrangements require trading participants (brokers) to report short sales by security to the ASX on a daily traded (not settled) basis. Trading participants will rely on their clients providing this information at the time of the order.
The ASX will then report this information after 9:00am each trading day. The report will show the volume of short sales executed on the previous day (except for financials which are still banned) and a ratio of short sales traded to issued capital for each security.
ASIC and ASX will use the data to assist in detecting market manipulation and other non-compliance with existing obligations.
Comment:
The focus on daily information is understandable and reflects current fears about the impact of short selling in stock prices. However, in practice daily reporting is likely to be seen to be unwarranted if global experiences are any guide. In the US, short interest is reported fortnightly and changes little from fortnight to fortnight. See the short interest report on Microsoft for example which shows one year of data for Short Interest, Avg Daily Share Volume and Days To Cover.
More importantly, the data collected is unusual in that it compiles transactions. This is not how information is presented on international exchanges - global best practice - which shows short interest positions in securities. If short interest positions were collected, then they could be compared with transaction volume in the security and answer such questions as how many days of trading volume does this short interest represent and how much does this short interest represent as a percentage of issued capital. This was highlighted in my post of 14 October titled "Exposure Drfat of the Corporations Amendment (Short Selling) Bill 2008".
Investors will find the publication of short interest positions valuable in their portfolio construction and risk management. Securities with high levels of short interest are at risk of a short squeeze in the event of new positive information. Some managers will be able to implement have risk limits that prohibit further short selling when short interest reaches certain threshold levels.
Unfortunately, to use the information gathered by the ASX to produce short interest positions would be a massive (impossible) exercise. There has to be another solution.
The natural reporting solution is to require short sellers or their custodians acting as agent to provide position information to the exchange.
This information would then be then compiled by the ASX for publication. As there will be fewer parties involved as compared with the current solution because custodians will represent many short sellers, the reporting process will likely be less of a burden and will provide more useful information.
Wednesday, October 29, 2008
Wednesday, October 22, 2008
Alphaville has published a very good article in FT.com titled "In Defence of Hedge Funds". A brief summary of the article is shown below.
The article quotes Dick Fuld recounting the position of the US Treasury towards hedge funds, "…kill the bad HFnds + heavily regulate the rest" that came from an email between Fuld and Lehman’s general counsel, Thomas Russo, recently made public by US Congress.
It’s right to say, as Peston does, that hedge funds were often the happy buyers of the lowest tranches of mortgage backed CDO's: the mezz and equity pieces that support above them a far greater number of AAA-rated senior tranches. In fact, the “toxicity” of CDOs relates to the AAA tranches which holders thought had little or no chance of default.
Smart money stopped buying the senior pieces a long time ago. Banks still wanted to issue CDOs though and needed AAA tranche buyers and built securities to carry these risks, some of which were held on their own balance sheets and have since taken large writedowns and suffered capital impairment charges. Greedy banks were the cause of their own demise.
The article quotes Dick Fuld recounting the position of the US Treasury towards hedge funds, "…kill the bad HFnds + heavily regulate the rest" that came from an email between Fuld and Lehman’s general counsel, Thomas Russo, recently made public by US Congress.
The banks were clearly successful in convincing the US Treasury that the banks were not to blame and that more liquidity and more confidence was needed, not more capital. While Paulson eventually came around to the view that the banks needed recapitalising, hedge funds are still in the target sights of regulators.
The BBC’s business editor Robert Peston is quoted as saying:
Really?
The article explains:
It’s right to say, as Peston does, that hedge funds were often the happy buyers of the lowest tranches of mortgage backed CDO's: the mezz and equity pieces that support above them a far greater number of AAA-rated senior tranches. In fact, the “toxicity” of CDOs relates to the AAA tranches which holders thought had little or no chance of default.
Smart money stopped buying the senior pieces a long time ago. Banks still wanted to issue CDOs though and needed AAA tranche buyers and built securities to carry these risks, some of which were held on their own balance sheets and have since taken large writedowns and suffered capital impairment charges. Greedy banks were the cause of their own demise.
Secondly - on “the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms”.
The article points out that you don’t need shorting to make people panic about banking confidence. It shows how the FTSE fared after the FSA banned shorting financials (indicated below by the vertical blue line):
Volatility increased and, after an initial rally, the market simply continued on its secular trend. This was the case in Australia also, as shown in my earlier post titled "Australia's Short Selling Ban - One Day Wonder?"
Thirdly - on “massive automatic sales of assets in a falling market”.
The article makes the point that sales by hedge funds have been driven by redemptions that in turn have been adversley impacted by falling confidence. Another cause of the fall has been margin calls made by the banks themselves.
The article concludes that the investment banks are the arhitects of this crisis, not hedge funds.
Tuesday, October 14, 2008
Exposure Draft of the Corporations Amendment (Short Selling) Bill 2008
The Australian Treasury are seeking comments on their short selling exposure draft. The current legislation around short selling is complex and unclear and the absence of reporting covered short selling has heightened uncertainty about its real impact and contributed to a 30 day temporary ban being imposed on 21 September 2008.
I believe that concerns about the impact of short selling on the general level of sharemarkets is overstated, and that while there are benefits in producing clearer legislation in the area, it will do little to address the current difficulties facing the Australian and global financial systems.
I believe that concerns about the impact of short selling on the general level of sharemarkets is overstated, and that while there are benefits in producing clearer legislation in the area, it will do little to address the current difficulties facing the Australian and global financial systems.
I am concerned that para 14 says "The Bill will replace ASIC's interim reporting requirements for covered short sales ..." If the temporary ban on short selling remains in place until the Bill becomes an Act, then the Australian financial system will be seriously impacted in the meantime.
Notwithstanding these high level comments, the draft is well balanced and shows a good understanding of the issues. I note para 16 in particular which says that "The Government is not seeking to prohibit or discourage covered short selling activity." That's good.
The draft distinguishes between naked and covered short sales. This distinction is relevant in relation to the current interpretation of the reporting requirement for short sales. Beyond that, a short sale is a short sale and the economic impact of being naked or covered is not relevant. This is a red herring in the argument.
Para 16 uses stock lending activity to estimate an upper limit of short selling in Australian listed securities of 4%. It notes that stock lending can be used for other purposes than short selling. However, there is no discussion of the likelihood that stock lending transactions may pass through many hands (it is a deep and liquid market) before it finally reaches a short seller. I have no evidence to support this, but typically a fund manager will ask their prime broker for stock availability. The prime broker may draw the stock from their own/their client's inventory or go to the market to borrow the stock for the manager. To the extent this occurs, stock lending activity will further overestimate short selling.
Para 22 argues that the absence of transparency in short selling may adversely impact investor confidence and market integrity, increasing the cost of capital and reducing investment activity. I would argue that the absence of short selling brought about by the temporary ban will also have this impact.
Para 23 discusses objectives. The first two points are side benefits to investors, but are inappropriate as objectives for any legislation. Providing information that is hard earned by one set of participants freely to others is unfair and unbalanced. In the case of the first point, "to provide a signal that individual securities may be overvalued", assumes that short sellers are better judges of share value than other investors ie those holding the investments long. This is not necessarily the case. If it is the case, then why should legislation be introduced that makes it easier for poorer judges of value?
The discussion of gross or net reporting of short sales is not relevant. Only net short selling will have an economic impact.
The main weakness of option two (para 26) is that reporting will be made on a trade basis. This implies a significant accounting requirement to follow through the impact of the sale on existing positions and to correct for any trade failures etc. Is the position opening a new short sale, extending an existing, reducing an existing ie a purchase.
It will be more straight forward to report positions and not trades at designated points of time. This information should be published from the source of truth, which is not the trade advice received by the broker. Typically brokers do not carry a record of holdings for their clients and investors may use multiple brokers to achieve a desired position.
I believe the best source of this information is held by the investor or as is generally the case, the investor's agent, the custodian or sub-custodian. Custodian's that carry short positions on behalf of clients already capture, settle and report this data daily on a traded and settled basis. Positions will also include off-market transactions for which they act as custodian. There are fewer custodians, than either investors or brokers. This alternative was not mentioned at all in the exposure draft, but is likely to be the preferred route and impose lowest regulatory cost.
Also not mentioned is that Short Interest has been captured in other markets for some time. In the US, Short Interest is published by major exchanges fortnightly eg http://www.nasdaq.com/aspxcontent/shortinterests.aspx?symbol=MSFT&selected=MSFT shows Microsoft's Short Interest history. What is the process employed in these markets? Can it be applied in Australia?
Will there be areas of activity not captured by using custodians? Offshore investors will presumably use sub-custodians. Users of direct market access systems will report trades to their custodian for setlement. Broker's principal positions? Anything else?
Para 34 discusses the problem of different trading desk activity in the same firm. Using the custodian approach, each account will be aggregated across every security. The fact that some houses will have offsetting long positions is not relevant. The fact that one group in the house has borrowed stock (or sold in advance of borrowing stock or settling) as principal or for a client is what is required to be captured, and will be captured using this approach.
Para 34 also discusses whether short sale reporting should be delayed. The concern presently is that the data should be provided frequently and quickly as it is believed to be materially important. However, international experience is that data provided fortnightly serves the market well. In fact, there is little movement from one fortnight to the next. But where there is a commercial advantage for short sellers in those markets, I believe it is sufficiently preserved with this level of periodic reporting.
In summary, the use of brokers to collect short sale trade information at the point of the trade is not the most effective way of achieving the desired outcome. Periodic position reporting by custodians, and investors that do not have custodians, is likely to provide adequate transparency of short selling in Australian securities.
Sunday, October 12, 2008
Australia's Short Selling Ban - One Day Wonder?
We are now half way through the 30 day prohibition of covered short selling in Australia. Has it been effective?
On Sunday 21 September 2008, ASIC imposed a total ban on covered short selling securities on the Australian Securities Exchange. (Naked short selling and covered short selling of financial securities were banned on 19 September 2008.) The reasons for the total short selling ban were given as:
Not surprisingly, the ban had the desired impact immediately after announcement, but why did it fail to provide support in the two weeks that followed?
The simple reason for this is that as short selling had little to do with the crisis enveloping the Australian sharemarket and other global sharemarkets, imposing a short selling ban was never going to provide the solution. The crisis brought about by financial companies leveraging exposure to falling asset prices continues to unfold.
Now that the short term supply/demand impact of the ban has passed, longer term factors are emerging.
For example, the most prevalent hedge fund strategy in Australia is equity long/short; whereby managers invest in Australian companies expected to outperform and offset these investments with short sales. Most equity long/short managers are net long investors. A small number of managers will seek to be market neutral. Few will carry net short positions, even in exceptional circumstances.
Banning short selling prevents equity long/short managers from effecting their strategy. As these managers abandon the strategy because they cannot manage the short side, they will be closing short sales AND and selling long positions. As these managers are generally net long, this is likely to have a depressing impact on share prices.
Those equity long/short managers holding on to their existing short sales awaiting a lift in the ban, will not be inclined to close those positions as further short sales in other securities cannot be opened to provide cover for long investments. This will have the effect of REDUCING buying in companies under sharemarket pressure, when short sellers would otherwise be buying to cover their positions, further depressing share prices.
Furthermore, the ban has increased uncertainty for many investors reducing their appetite to hold Australian shares and further depressing share prices.
In summary, while the covered short selling ban had the desired impact on the first day of trading following the ban, it appears to have been ineffective in achieving the desired aims of the ban, as we have seen:
On Sunday 21 September 2008, ASIC imposed a total ban on covered short selling securities on the Australian Securities Exchange. (Naked short selling and covered short selling of financial securities were banned on 19 September 2008.) The reasons for the total short selling ban were given as:
- short selling of stocks, particularly financial stocks, may be causing unwarranted price fluctuations.
- necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets.
- a circuit breaker to assist in maintaining and restoring confidence
Security | Share Price Increase | Share Price Decline |
Financials (XFJ) | +5.1% | -18.5% |
+8.1% | -20.1% | |
+6.0% | -11.3% | |
+5.3% | -24.6% | |
+5.7% | -14.4% | |
+4.9% | -18.3% | |
Materials (XMJ) | +9.8% | -30.2% |
+12.2% | -30.1% | |
+25.4% | -62.5% | |
+9.4% | -34.2% | |
All Ordinaries (XAO) | +4.3% | -22.0% |
Not surprisingly, the ban had the desired impact immediately after announcement, but why did it fail to provide support in the two weeks that followed?
The simple reason for this is that as short selling had little to do with the crisis enveloping the Australian sharemarket and other global sharemarkets, imposing a short selling ban was never going to provide the solution. The crisis brought about by financial companies leveraging exposure to falling asset prices continues to unfold.
Now that the short term supply/demand impact of the ban has passed, longer term factors are emerging.
For example, the most prevalent hedge fund strategy in Australia is equity long/short; whereby managers invest in Australian companies expected to outperform and offset these investments with short sales. Most equity long/short managers are net long investors. A small number of managers will seek to be market neutral. Few will carry net short positions, even in exceptional circumstances.
Banning short selling prevents equity long/short managers from effecting their strategy. As these managers abandon the strategy because they cannot manage the short side, they will be closing short sales AND and selling long positions. As these managers are generally net long, this is likely to have a depressing impact on share prices.
Those equity long/short managers holding on to their existing short sales awaiting a lift in the ban, will not be inclined to close those positions as further short sales in other securities cannot be opened to provide cover for long investments. This will have the effect of REDUCING buying in companies under sharemarket pressure, when short sellers would otherwise be buying to cover their positions, further depressing share prices.
Furthermore, the ban has increased uncertainty for many investors reducing their appetite to hold Australian shares and further depressing share prices.
In summary, while the covered short selling ban had the desired impact on the first day of trading following the ban, it appears to have been ineffective in achieving the desired aims of the ban, as we have seen:
- heightened fluctuations (falls) in share prices
- unfair and disorderly markets
- reduced investor confidence
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