30/06/2010 Author: Christopher Miller

Comment: Christopher Miller

The recent public consultation paper from the European Commission (EC) on short-selling should be welcomed as an opportunity for open discussion on the subject. Most of the document is framed in independent terms, rather than using too many leading questions, which is laudable. However, there remain parts that are less than fully even-handed, especially in the final section on the “emergency powers of competent authorities”.

In case you were wondering what these “competent authorities” are, the glossary helpfully clarifies: “...shall mean the competent authority designated for the purposes of the legislation.”  Or what you or I would call ‘national regulators’. One question is notable, asking: “Are the emergency powers given to competent authorities, and the procedures for their use, appropriate?”

This is interesting because the proposals in front of the EC actually restrict the behaviour of currently existing national regulators, by giving the proposed European Securities and Markets Authority (ESMA) power to direct national regulators in certain circumstances. And this consultation separately proposes certain other requirements on national regulators.

So, underlying this is the basic assumption of further relinquishment of sovereign powers. We will have to see how the UK coalition government handles this in the light of commitments not to release further powers to Brussels.
The paper is well-informed about the benefits of short-selling, but I fear that it nevertheless tries to discriminate against short-sellers. For example, it asks whether there should be powers to impose short-term restrictions on short-selling if there is a significant price fall, like 10%.

There are countries with far more experience than we have in dealing with wild price fluctuations, many of them in developing markets. India is a market I know quite well, and they have operated there for many years with a circuit breaker system. If a particular share or index exceeds limit levels, all trading is suspended for a specified period. Sometimes shares can go limit up or down for days in a row, but often, the circuit breakers restrict hysterical over-reactions and excessive momentum buying or selling, but they do not discriminate between different types of market participant, unlike the EC proposals.

The paper asks for evidence of the risks of short-selling, but strangely, does not ask for evidence that short-selling does not pose risks. Considerable research has been done on the short-selling bans during the credit crisis. It was demonstrated beyond any doubt that the bans had no discernible benefit to the markets or volatility, and that there was probably less liquidity available as a result.

Bank stocks, Credit Default Obligations (CDO) and Greek sovereign debt all have something in common, which goes deeper than the fact that hedge funds had been shorting them. Hedge funds are not generally accused of being the dumbest people in the market, so in general they tended to take out short positions very early on, before the consensus caught on to sell. As a result, hedge funds barely showed up in these events, except as buyers to close out their positions at a profit. Research into Greek debt trading showed that CDS prices lagged behind the physical market. So while hedge funds were being blamed for using CDS insurance to drive down the market, the evidence demonstrated beyond any doubt whatsoever that sales in the physical market were driving the CDS price down. And we now know that it was all justified.

The furore about the incentives provided by CDS instruments continues unabated. What most CDS commentators fail to highlight is that, other than the lack of requirement to borrow the stock, the payoff profile is almost identical to other ways of taking a short position. CDS is not really so very different or more dangerous than other beneficial instruments.

While I believe that the anti-short selling faction is hysterical and at times wilfully ignorant, I would support greater market transparency, especially reporting to regulators. Regulators cannot make good decisions without good information, and restricting reporting to certain instruments in the hands of some market participants gives regulators an incomplete picture. In addition, it is easier for managers to copy all trade information to the regulator as well as the administrator, rather than to filter and process the data according to outdated and irrelevant rules which do not take into account current instruments and market practices.

Christopher Miller is CEO of Investment Quotient, a financial research consultancy