Opinion: The futility of short selling restrictions

Date: Wednesday, September 28, 2011
Author: COO Connect

As short-selling restrictions in several eurozone countries are nearing their end, COO Connect looks at the pointlessness of these temporary bans.

Pursuing short-sellers during financial crises in the interests of political expediency has always been a useful tool for governments. The concept whereby a trader holds negative opinions on a stock has always been viewed with contempt ever since short-selling began in the Netherlands more than four centuries ago.

However, history has repeatedly shown us short-selling is an essential market activity. It helps liquidity, price discovery and the facilitation of risk management. In 2008, US and European short selling bans on financial institutions ultimately exacerbated illiquidity and financial stocks still continued their nosedive. Even Christopher Cox, chairman of the US Securities and Exchange Commission (SEC) during the crisis, acknowledged the three week short selling ban was the biggest mistake of his term. Countless 2008 autopsy reports by academics and regulatory bodies have agreed. In August, the EDHEC Risk Institute said short-selling bans damaged liquidity and aggravated the woes of struggling stocks. The UK’s Financial Services Authority (FSA) and the Committee of European Securities Regulators (CESR), the precursor to the European Securities and Markets Authority (ESMA), said short-selling was often a force for good and helped mitigate market risk.

Quite why France, Belgium, Spain, Italy, South Korea and the perennial economic basket-case that is Greece imposed temporary restrictions on short-selling their banks is astounding. Banning short-selling does not solve problems. It hurts more people than it helps. Pension funds, for example, routinely short stock not because they hold an opinion on it but because they want to hedge their risk. Furthermore, the supposed beneficiaries of the bans – the banks – are still being pummelled in the market. Take some of France’s main banks. Moody’s reduced the credit ratings of Credit Agricole and Societe Generale from Aa1 to Aa2 and Aa2 to Aa3 respectively. BNP Paribas’ rating is currently under review. These downgrades reiterate the sheer futility of short-selling restrictions. These banks are not suffering because hedge funds are ruthlessly betting against them. No, these banks are stumbling because long-only and long-termist investors are pulling out their capital.

Perversely, these restrictions might actually have the opposite effect of what the politicians intended. Only five out of 27 eurozone countries imposed the ban indicating divisions within ESMA. The UK flatly refused to follow suit. Even among those eurozone states which adopted bans, there was inconsistency. French short selling restrictions applied only to shares and convertibles while the Spanish ban extended to derivatives. Not only was there regulatory arbitrage but the bans proved totally ineffective. Perhaps this might herald some new thinking in the European Union (EU)? It could even undermine the case for the EU’s short selling directive or at least temper some of the more onerous aspects of it. However, assuming common sense will prevail among politicians is often a tough ask. The likely reality is these bans will continue in dribs and drabs during periods of market volatility for years to come.