Renewing the Short Selling debate in Europe

Introduction

Short selling has been one of the more popularized economic concepts in the recent financial crisis; in fact, almost “no subject in securities regulation has generated more heat and less light than short selling.”[1] It has been on top of the political agenda of all major financial centres as numerous prohibitions of different types have been intermittently enacted and repeatedly amended within the past five years. Yet, regulation of short sales is not merely a question of complex economic calibration; rather, legislators are faced with a conflict between economic theory and what politics – and ultimately the electorate – demands. Popular sentiment and corporate representatives jointly “rail against short selling as a manipulative tool that artificially pushes share prices below their fundamental values.”[2] At the same time, scores of economists (and often even the regulatory authorities) have recognised that short selling presents tangible economic benefits for the efficient functioning and pricing of capital markets. This comment will address the current regulatory restrictions present in European countries as well as the EC proposal for a uniform regulation of short sales across Europe.

Definition

A short sale is defined by the federal authorities as the “sale of a security that the seller does not own or any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller.” [3] Since the seller does not own the security, “in order to deliver the security to the purchaser, the short seller will [later] borrow the security, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by purchasing equivalent securities on the open market…”[4] Essentially, a short sale is a pessimistic judgment of a firm’s performance. Rather than abiding by the traditional model of buying low and selling high, a short seller is selling at a high price and later buying low.

Short sales can be subcategorized as either naked or covered. In a covered short sale, the seller’s sale of the securities is “covered” by the loan of securities from an initial broker.[5] After the seller delivers the securities to the purchaser, he will purchase an equivalent number to return to the initial lender/broker. In a naked short sale instead, the seller does not currently own or possess the securities at the time of the transaction. Consequently, after the sale, the short seller must both purchase the securities to honour the transaction and deliver them.

A short seller generates a profit if he can purchase the securities at the subsequent stage (whether to repay the broker or to honour the transaction with the purchaser) at a price inferior than what he received from the sale.[6] Consequently, purely as a matter of common sense, there is a perverse incentive for short sellers to hope that the share price of the security with which they transacted plummets. The more the share price decreases, the greater the profit from the repurchase. In fact, if on the other hand, the price of the security were to increase (rather than decrease), a short seller would face a potentially unlimited liability to the purchaser.[7]

Economists highlight how there are non-speculative reasons for shorting stock. An investor may be involved in a convertible bond arbitrage, or may be hedging his stock ownership trying to capture pricing discrepancies by selling short while also simultaneously retaining long positions. [8] Similarly, some argue that short-selling is almost an inevitable consequence of the free capital market. A short seller is pessimist “about the value of the stock,” but his negative influence is counterbalanced   by optimists who think the “stock worth more than the short-sale price.”[9] Consequently, unless the short seller is trading on non-public information, “all that short selling proves is a diversity of opinion about the company’s future.”[10]

Economic Implications of Short Selling

Economists have repeatedly emphasized a variety of significant benefits for capital markets which tolerate short selling practices. Extensive empirical studies suggest that short sales significantly affect the liquidity and efficiency of a particular capital market. [11]  Accordingly, measures which ban short sales have the effect of reducing market liquidity and hindering “price discovery.”[12]

In fact, recent studies addressing the consequences of the short sales ban enacted in the wake of the Lehman bankruptcy have outlined how stocks which were subject to the prohibition on short sales deteriorated significantly. [13] If one thinks that short sales account for 31% of all sales for NASDAQ listed stocks and 24% of all NYSE listed stocks, [14] then clearly a ban on short sales will have a significant impact on those traders who will no longer access the market.

Besides from liquidity, price discovery is hindered because informed investors (investors which have investigated a company’s financial performance and judged a negative future cash flow) are not permitted to benefit from their investigation by profiting from the company’s overpriced share valuation. [15] Short selling effectively permits an investor to express a negative judgment of a company, while permitting that judgment to be readily assimilated in the company’s share price. Banning short selling means that there are effectively primarily optimistic share holders on the market. [16] Thus, a prohibition on short sales restricts the heterogeneity of shareholder beliefs, and may lead to “overpricing” of company stock as no investor can contest the judgment. [17] To a certain extent, short selling provides a useful cautionary brake of inflated stock prices. This is especially helpful in the instances where a stock price is inflated for fraudulent purposes.

On the other hand, economists also acknowledge that short sales are prone to abuse. Price manipulation is possible even in cases where the short seller does not believe the stock to be overpriced. This is of particular concern in cases where the short-seller/investor is bound by a contractual obligation which is itself indexed to a particular stock value – in that case, if the share price of the indexed company were to decrease, the short seller would profit significantly in his repayment. [18]

Regulatory Response

Regardless of the plausibility of economic theories, institutional concern with short sales is long dated. Sir John Barnard’s Act “declared void all contracts for the sale of stock which the seller was not actually possessed of or entitled to at the time the contract was entered into” addressing the issue of short sales as far back as 1735.[19] Hostility towards short sales is exacerbated by financial crises, and the recent 2007-09 financial meltdown was no exception. Virtually all western countries adopted some form of regulatory restriction on short sales in late 2008-2009, and all major financial institutions became involved.

The sovereign debt crisis of 2011 sparked intensified agency regulation of short sales as France,[20] Spain,[21] Belgium,[22] Greece[23] and Italy[24] introduced short selling bans lasting for most of the autumn season.  Concurrently, Austria had extended its short selling ban on four heavily traded stocks,[25]  and only regulated short selling is permitted in Germany.[26] Greater flexibility is permitted in Poland[27] and the United Kingdom (albeit with a disclosure requirement).[28] Other countries do not regulate short sales, such as Czech Republic, Cyprus, Latvia and Malta primarily because the practice is not widespread.[29]

Upon this disparate regulatory background, the European Council and Parliament voted to promulgate a Regulation on Short Selling by the end of 2012.[30] The European Securities and Markets Authority (“ESMA”) is currently evaluating technical standards for the regulation,[31] and will submit its official response by March 2012.

Clearly, a uniform European Regulation of the practice would send an important signal to financial operators across the world. In light of the current scepticism of short sales, it is fundamental that such an important step be taken in full consideration of the insightful evidence from recent studies on short selling bans in Europe.

Jacopo Crivellaro