Short-selling: scapegoat?

Plenty of investors have been profiting from the recent period of economic gloom. Short selling or 'shorting' -- the practice of selling the paper of embattled companies the seller does not own -- has helped investors swell their returns even as asset prices plunge. Whether you consider the practice to be skulduggery or Hobbesian investment cunning designed to take advantage of increasingly volatile share markets, the regulators are circling.

Starting this week, traders in UK shares must disclose any short position -- bets a stock will fall -- of more than 0.25% in a company trying to raise capital through rights issues. The United Kingdom's main financial regulatory agency, the Financial Services Authority, hopes the rules will stabilise increasingly volatile share markets, and discourage short selling stock.

Reactions to the measure will fall into two camps. Some investors -- no doubt those who profit from the practice -- will be outraged; they need to keep their trading activities secret so others cannot dilute their potential returns. Those who do not short stock will welcome the measure as a step towards increased market transparency and confidence.

In some ways, shorting stock is the bearish half of speculation. Yet the feverish conditions of a rights issue often make it easier for short sellers to sow false rumours, thereby undermining capital raisings and sparking further declines in stock. Robert Peston writes in his BBC blog that it was not clear that the recent falls in the prices of HBOS and Royal Bank of Scotland -- both trying to raise huge sums in rights issues of new shares -- were products of a genuinely bleak trading outlook or the "self-fuelling consequences of a dangerous short-selling feedback loop".

Short selling is certainly a scapegoat during lean times; regulations governing the practice were implemented in the United States after the Wall Street Crash in 1929, and again in 1940. Investors were prevented from shorting shares during a downtick in the market; this was known as the uptick rule, and was in effect until 2007.  President Herbert Hoover condemned short sellers and the first Director of the FBI, J. Edgar Hoover, vowed to investigate short sellers for their role in prolonging the Depression.

Nowadays in the United States, there is no rule requiring short sellers to disclose their position in a company, but shares in a company's initial public offering cannot be sold short until a month after the IPO. Yet many other countries, such as Canada, do not have this restriction.

Short selling has many defenders. It can certainly leaven overvalued stock and play a role in setting fair prices for securities and commodities. For example, the short selling hedge fund Kynikos identified US energy giant Enron as a stock market blimp, and became an early short seller of the stock. When the Enron scandal was out in the open, Kynikos profited greatly and made a multi-millionaire celebrity out of hedge fund head James Chanos.

The FT even argues that the problem in many financial markets is the lack of short selling, pointing out that a false market caused by insufficient short selling would be considerably worse and that the seesaw of different views makes markets effective at valuing a security.

MoneyWeek's Tom Bulford disagrees that short selling contributes to the accurate pricing of financial assets. He points to a paper released last year by the London School of Economics, that found not only no lessening of volatility but also that the stock market's blue-chip share indices, representing shares in established companies, were more volatile than the indices of risky small companies.

The 'culprits' of this volatility are traders with a short time horizon operating in large liquid shares -- usually hedge funds with more leverage than pension and other long term funds, who need to turn in good results every quarter. As Peston writes, large institutional investors may even be fuelling the short selling by lending hedge funds huge chunks of stock, thereby undermining the value of the shares they own.

Yet Bulford makes the most compelling argument against the short sellers. To avoid crisis, a financial system needs a positive, constructive mindset that looks beyond the gains to be made in a few weeks and months. "The mindset of short sellers is quite the opposite," he writes.