Short Sales Bans - Help or Hinderance?

Now that the dust has settled on the action taken to limit short selling during the financial crisis, The Centre for Economic Policy Research has prepared a report that examines how effective the bans were.

The Centre sifted through the evidence generated by the various regime changes to investigate the impact of the bans on liquidity, price discovery and stock returns.

Since the bans were enacted and lifted at different dates in different countries, and in some countries applied to financial stocks only, they were able to identify their effects with panel data techniques ie data containing observations on multiple phenomena observed over multiple time periods.

In summary, they have concluded that the bans:

1. were detrimental for liquidity, especially for stocks with small market capitalization and high volatility;
2. slowed down price discovery, especially in bear market phases, and
3. failed to support stock prices

Short Selling Disclosure Regulations

Financial Services Minister Chris Bowen has released Short Selling Disclosure Regulations attached to the Corporations Amendment (Short Selling) Act 2008. The Regulations require that share investors report covered short sale transactions to brokers as is currently the case, and in addition, effective 1 April 2010, report positional short positions to ASIC which will be aggregated and reported with a 4 day lag.

The acknowledgement of the value of positional reporting is commendable. However, retaining the transactional reporting requirement is difficult to understand given the cost involved and in view of the fact that it is partial and misleading (see earlier post).

The announcement is silent on how the positional information is to be conveyed, whether it is direct or via prime brokers/custodians as discussed in the 6 March Treasury Consultation Paper. How will foreign investors be enforced to provide data and how will ASIC achieve the aggregation task?

All this effort and expense to justify a mechanism designed to report positions that according to the Australian Treasury represent an upper limit of 4% of total market capitalisation. Once a record of short positions is established and proper analysis is conducted will the cost of this dual reporting approach be seen to be justified?

The 7 Habits of Highly Suspicious Hedge Funds

In a post-Madoff world this blog post from Rick Bookstabber titled "The 7 Habits of Highly Suspicious Hedge Funds" makes good reading.

It confirms my thinking that hedge funds will fall into two broad groups going forward. First, those that operate under a veil of secrecy and use leverage and sometimes unlisted securities. And then there are those that rely on an open and transparent process with listed securities and no leverage.

The key safety factor for investors is the separation of custody and administration from investment management. Not just Chinese wall separation, but real separation. In Australia, the role of independent Responsible Entity provides that separation for retail investors and other investors participating in an ASIC registered Product Disclosure Statement. For institutional investors using managed accounts, the role of custody and investment management is clearly separated.

For investment managers that are also Responsible Entity and perform custody and administration functions, the burden of ensuring separation of roles is necessarily greater.

Funds that have open and transparent processes, that don't require leverage to produce returns and are prepared to publish holdings (even with a lag) will be more likely to gain the confidence of investors.

ASIC Removes Short Sale Ban

The short selling ban on Australian listed financial securities was finally lifted by the Australian Securities & Exchange Commission (ASIC) effective 25 May 2009. The ban on financials extended beyond the two month ban placed on all securities that was lifted on 19 November 2009, because of concerns about systemic risk associoated with financial securities.

With some stability resuming in financial markets, and presumably assured by the benefit of the new reporting on gross short sales introduced on 19 November 2009, ASIC weighed up the market efficiency benefits in lifting the ban.

ASIC reserved the right to reimpose the short sale ban without consultation if they deemed it necessary. Disturbingly, ASIC referred specifically to activity by "hedge funds and similar institutions" in the same paragraph, suggesting that hedge fund activity was somehow a potential threat to an orderly market. Yet there is no such evidence that short selling does have an adverse impact on share prices, let alone that hedge funds are specifically involved in such activities.

Still on the horizon is clarification about the the form of short selling reporting that will be adopted going forward and whether the partial and potentially misleading current gross short selling regime will be persisted with.

Australian Treasury Short Selling Consultation Paper

The Australian Treasury released a consultation paper titled "Short Selling Regime" on Friday 6 March. The paper calls for comments no later than 3 April 2009.

The Treasury paper follows the enactment of the Corporations Amendment (Short Selling) Act 2008 in December 2008 and presumably will assist in the drafting of regulations supporting the Act. Given the objective of the new legislation is to "enhance market confidence and integrity by providing greater transparency to both investors and regulatory bodies about short selling activity on Australian financial markets" its success will be dominated by the successful drafting of the regulations. So this is definitely a paper that is worth commenting on!

The paper refers to the improvement in confidence that might be generated by the short selling information and the reduced potential for rumour and speculation surrounding the activities of short sellers. The reporting should answer once and for all whether short selling really is a tool for market manipulators or not.

The paper makes the distinction between two methods of reporting of short sales; transactional (currently known as gross short sales and represented by the interim disclosure requirements imposed by ASIC) and positional (net short sales).

Positional reporting is more accurate than transactional reporting because it also takes into account transactions that close-out short positions. This is a very important difference. There is a high likelihood that transactional reporting can be misleading, making it unsuitable for reporting.

Treasury note that the Reserve Bank of Australia are pursuing additional disclosure of stock lending information as a complement to other short selling information, even though it is widely accepted that security lending data is a poor proxy for short selling. The risk here is that a second partial source of short selling data is added that also has a high likelihood of being misleading.

Layering ad hoc and partial measures of short selling is the worst of all worlds particularly, as will likely be discovered once sufficient information is collected, short selling is not so influential an impact on share prices as regulators and commentators believe. If we follow this course we will have constructed a costly and misleading infrastructure of reporting mechanisms that add little to market integrity. Transactional reporting should be dismantled once a superior method is in place, and the new RBA security lending reporting should not be pursued so that the focus can be on delivering the best possible solution.

While there will be difficulties in implementing a positional reporting regime, such difficulties are not sufficient reason to rely on poor and misleading proxies instead. Treasury refer to two such potential issues - implementing threshold reporting and dealing with investors in other jurisdictions.

Threshold reporting means excluding investors with only small short positions from the obligation to report. While in theory this would appear to be a sensible and practical initiative, and has been adopted in the UK, in practice it has serious shortcomings:

• It will not be as accurate as collecting total data and therefore risk being misleading as is the case for transactional and security lending reporting; and
  
• It is likely to be easier for investors to report total positions than to extract positions above a threshold, without significant system development

Positional reporting puts the onus on investors or their agents to provide short selling data. While in theory offshore investors may not be able to be easily compelled to provide information, they will operate with sub-custodians in the Australian market that may be able to be compelled to do so.

There is some discussion of the timing and frequency of reported data.

• On timing, fairness (and thus market efficiency) dictates that only aggregate security data is released, and is released with a lag so as not to encourage front running strategies (akin to encouraging trading on rumour) or discourage short selling activities.
• Cost is a major factor in determining frequency, although unless short sale positions are expected to be highly variable, frequent reporting would not be justified. (Note there is an expectation among regulators and commentators that short sale positions are highly variable. This is not borne out by experience overseas and should not be assumed without evidence in developing the Australian reporting regime.)

Discussion to date on short sale reporting, including this consultation paper, has generally assumed that short selling is a dominant influence on share price movements. Thus, greater transparency of reporting is warranted. However, this is not supported by any evidence. Consideration of the cost of implementing enhanced disclosure should also include the possibility that the additional information resulting from the short selling regime will not improve market effectiveness, because short selling has been dramatically overstated as a source of share price movements. (Note: while short selling as been under the spotlight for its potential to disrupt markets in fact it has been the ban on short sales itself that has been associated with reduced market confidence, reduced market liquidity and reduced market integrity.)

Nevertheless, there will be enhanced short sale reporting as this is what is dictated by the new legislation. The first benefit will be that if not already removed, the current ban on financials will finally be lifted. Then, if positional reporting is adopted, there will be the benefit that it will be clear for all to see what impact, if any, short selling might be having on a security price, rather than unfounded accusations that short sellers are the root cause of share price declines.

In summary, we should work towards a single best method for reporting sales that is consistent with global practice (and dismantle current partial misleading reporting) that enables aggregate short sale positions to be reported periodically with a lag. For the record I expect this data to show that the impact of short selling on share price movements, and thus the need for this additional reporting, has been dramatically overstated.

In answer to the issues for comment in the Treasury paper;

A. Positional reporting should be used in isolation because the current transactional reporting is misleading.

B. The stock lending reporting proposed by the RBA should not be pursued because it is likely to be a misleading source of short sale information.

C. Investors or their agents should be responsible for reporting short sale information because this information is already to hand and while it will take effort to effect the resulting positional reporting will deliver best available short sale information.

D. Custodian/prime brokers carry sufficient information about client's short sale data. The majority of short sellers will have some custodian/prime broker relationship in place to effect settlements and hold securities.

E. Offshore investors will generally operate with custodians that in turn have sub-custodian arrangements in Australia to effect settlements and hold securities.

F. Market operator will carry other relevant information about securities such as market capitalisation and likely be in a position to add short sale information easier than the regulator.

G. I believe that a threshold for reporting will be more difficult to implement than full reporting and will be more accurate. The costs for full reporting could be minimised by appropriate periodic reporting.

H. Refers to number of short positions excluded if various thresholds applied. Will disadvantage large managers who will more likely have positions above the threshold.

I. Current US position is for fortnightly reporting via market operator. Adopt lag in keeping with global practice. If the lag is reduced to 1 week globally adopt 1 week otherwise retain fortnightly.

J. Banded disclosure is difficult and costly to administer and relates to the influence of individual investors. The key is influence at the aggregate security level.

K. There should be a delay to avoid front running and to respect the effort that short sellers have invested in the decision they are making on behalf of their clients. Otherwise short selling is likely to be discouraged to the detriment of market integrity.

L. The data should be disclosed on an aggregate basis. As with K. above disclosing investor positions will encourage front running, fan rumour and discourage investors from short selling on behalf of their clients to the detriment of market integrity.

M. I agree aggregate disclosure could be misleading if a threshold is applied. As stated in G above more accurate reporting will result if no threshold is applied.

N. The identity of short sellers should not be disclosed whether threshold approach is applied or not. As with K and L above such an approach will encourage from running, fan rumours and discourage the use of short selling on behalf of clients to the detriment of market integrity.

O. Transactional reporting is misleading and should be dismantled as soon as a superior method of reporting is implemented. It is not a complement to position reporting.

P. Transactional reporting is flawed from the perspective of data collection (by way of brokers who are in a position to trade and profit from the additional reporting provided) and output (increased/decreased reported short sale activity may not be associated with a net increase/decrease in short sale positions and thus is misleading).

Q. If positional reporting is made mandatory then all other misleading proxies should be removed.

R. The lag in reporting should reflect international practice. The lag should be sufficient to stem front running and fanning of rumour. Assuming data is aggregated the lag could be as short as 1 week.

S. It is difficult for individual investors to see evidence of front running from current reporting.

T. The current transactional reporting will mislead whenever material short sales are closed as these are not reported. It is also confusing to investors to see financials short sales reported when they are banned from being short sold.

U. - Z. seek responses on the cost of compliance. The two elements of cost will be system development and the cost of providing the data ongoing.

AA. The cost of compliance would be minimised if the best reporting approach was adopted and other misleading approaches dismantled or not pursued.

Reflections on the Extension on Short Selling Ban

The odd thing about the extension of the ban on short selling is that the major Australian banks have re-capitalised, won market market share and are well positioned compared to their international counterparts. Yet, financials are not protected from short selling in other developed markets.

Does the Government know something about the strength of the Australian banks that the market does not know? Unlikely. Are they worried about some financial institutions in particular and the systemic risk of a bank failure? Possibly.

Then, putting aside the fact that there is no evidence to support the effectiveness of the ban, the resulting market inefficiency can be considered a tax on investors. Rather than lay the cost of this support on investors, it would be fairer to make specific provision by providing direct capital support to the organisation(s) they believe carry systemic risk. As the ban on short selling is likely to be ineffective, this is a likely eventuality in any case.

The markets could then be left to find equilibrium, operate effectively and re-build the confidence that has been lost as a result of the short selling bans applied to date.

ASIC Extends Short Selling Ban on Financials Again

Oh dear again. ASIC has again bowed to market rumours of potential predatory short selling, announcing today that it has extended the ban on covered short selling of financial securities until 31 May 2009.

This decision was made despite the fact that:

• Australia stands alone among the developed markets in maintaining any ban on short selling;
• derivative or exposure based short selling is not banned, thus allowing alternative (though potentially more expensive) avenues for selling; and
• the share prices of financials have underperformed the broader market over the period they have been afforded special short selling protection - All Ordinaries -14.3% vs Financials -21.7% 13 November 2008 to 5 March 2009.
  

ASIC does acknowledge that there may be a possible loss of market efficiency or price discovery as the result of the continuation of the ban, but that this is justified given the current market circumstances. The assumption here is that the ban will actually have an impact on the share prices of the companies being protected.

The decision was based on discussions with other regulators and market participants (including those who might naively expect to benefit from a continuation of the ban), but was not accompanied by any factual evidence that might support the decision.

Lets hope that by the time this decision is reviewed again, there is some reliable data available to help ASIC make a better informed decision.

AIMA Hedge Fund Booklet

In conjunction with Zenith Partners, the Alternative Investment Management Association (Australia Branch) has published the Hedge Fund Booklet.

The booklet is a valuable resource for anyone with an interest in hedge funds whether an investor, adviser, regulator, the general public and even managers themselves.

Amongst other things, it covers investment strategies and return attributes and discusses the impact on broader portfolios of allocating to hedge fund strategies. There is a very useful glossary of terms.

The booklet is another important step in demystifying hedge funds and allowing investors and their advisers to make better qualified portfolio management decisions.

Australia Extends Short Selling Ban on Financials

Oh dear. The Australian Securities and Investments Commission has extended the ban on short-selling financials to 6 March 2009.

But what were they thinking?

ASIC has described the decision as a cautious one, responding to the renewed selling in financials in London and New York that coincided with the lifting of the ban on short selling financials in the UK on 16 January 2009.

But by acting differently to other regulators globally, and in view of Australia's large weight to financials, it is a risky decision that is likely to further tarnish our reputation as a reliable financial market.

There is no evidence that such bans have been effective in achieving higher share prices, or that when not in place, have resulted in lower share prices. A relative outperformance of financials in Australia of 8 percentage points over the period since the ban on non-financials was lifted has been touted as evidence that the ban has worked. But there are many factors at work in determining share prices not just short selling. The influence of short selling on share prices is just unsubstantiated heresay based on a fear of predatory practices; we need some solid evidence.

And what is the regulator, supposedly responsible for ensuring free and fair markets, doing trying to rig higher share prices for financial stocks? At the least they are terribly conflicted. At worst they are driving out investors (who want fair prices and access to short selling as a tool to manage risk), reducing market liquidity and the attractivess of the Australian market to raise capital and contributing to the undermining of Australia as a regional financial centre.

Impact of Short Sales Restrictions on Share Prices

A recent paper by Ian Marsh and Norman Niemer dated 30 November 2008 titled "The Impact of Short Sales Restrictions" is a timely one given some governments and regulators, including in Australia, are still forming views on the appropriate regulatory approach.

The authors were expecting to see an increase in skewness and a decrease in kurtosis as a measure of whether the short sale prohibition had been effective.

They found that the imposition of short selling restrictions had no discernible impact on the behaviour of stock returns.

The analysis was limited by the small number of observations when the restrictions were in place. In Australia of course the bans were in place longer and remain in place for financials. This may make further analysis more useful.

The study highlights the extreme position adopted by Australian regulators. The following table taken from p22 of the paper shows that Australia was the only country among the 17 developed countries in the sample that banned covered short sales of non-financial stocks as well as financial stocks - see highlighted column.

SEC's Cox Regrets Short Selling Ban

US Securities and Exchange Commission (SEC) Chariman Christopher Cox said he regrets his handling of the financial crisis and in particular the banning of short selling financial stocks.

The SEC and the UK's Financial Services Authority (FSA) introduced a temporay ban on short selling financial stocks like Morgan Stanley and Citigroup on 19 September 2008. The ban was lifted on 9 October 2008.

The SEC's office of economic analysis is still evaluating data from the temporary ban on short-selling. Importantly, Cox conceded that preliminary findings point to several unintended market consequences and side effects caused by the ban, such as reduced market liquidity.

"While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again," Cox told Reuters in a telephone interview from the SEC's Los Angeles office late on Tuesday. "The costs (of the short selling ban on financials) appear to outweigh the benefits."

The SEC imposed the temporary ban under intense pressure from the Federal Reserve and Treasury Department which insisted it was crucial to the short-term survival of these institutions, Cox said.

A few weeks after the temporary ban was lifted, global markets were again dropping precipitously, U.S. banks were begging the SEC to reinstate its short-sale ban and there was talk of shutting the markets down.

Australia faced a simliar set of circumstances to the US, except that the the Australian financial sector was in relatively stronger shape. The Australian regulator, the Austrailan Securities and Exchange Commission (ASIC), was under intense pressure from Australian banks, government agencies and the press to follow the lead of the US and UK regulators.

ASIC did respond on Friday 19 September 2008 in concert with the US and UK regulators and then, remarkably, imposed a sharper regulatory response on 21 September 2008, imposing a total ban on short selling. This temporary ban on short selling was not lifted until 13 November 2008 (over a month after the ban in the US was lifted), and the ban on financials remains, with a lift being foreshadowed (but not promised) for 27 January 2009.

How will history judge Australia's policy response? Given the deeper and more protracted bans, will the unintended consequences of these actions be even greater than Cox is indicating for the US?