Friday, August 12, 2011

Europe bans short selling - How effective will it be? A journey through History

Regulators in France, Spain, Belgium and Italy have banned short sales in select financial stocks for two weeks starting yesterday, as they try to limit the slide in these shares. With panic over the debt problems in the US and Europe spreading, regulators are using every weapon in their arsenal to prevent a vicious cycle of falling share prices and panic selling from exacerbating the woes of distressed financial institutions.

Is banning short sales an effective tool to calm the roiled markets? Doubtful, if past instances of similar actions by regulators in the US and UK, are any indication.

During the peak of the global markets crisis in 2008, US’ Securities Exchange Commission and UK’s Financial Services Authority banned short sales in many stocks between September 19 and October 7. The move at best had a neutral effect, as many stocks declined by as much as 20% during the ban period.

Later in December that year, SEC chairman Christopher Cox admitted that it was not the best of solutions.

"Knowing what we know now, [we] would not do it again. The costs appear to outweigh the benefits," he was quoted as saying.

Regulators can at best ban ‘naked’ short sales, where the seller does not have possession of the stock at the time of selling it. In such a trade, the seller is betting that the stock price will fall, and he will be able to buy it back at a lower price and make a profit.

Then there is ‘covered’ short sales, where a market participant may own an equivalent amount of the shares that he plans to short sell. If the price falls soon after the sell order, the seller may choose to square off his position the same day by buying a similar quantity, instead of delivering the shares to the broker.

The third type is borrowed short selling. In this, the seller borrows shares by paying a fee to the lender, and then dumps the shares in the market. The seller is hoping that the stock price will fall sharply enough for him to be able to make a decent profit after deducting the borrowing fee.

The regulator can curb this kind of short sales by either banning borrowing of shares, or hiking margins on such deals, or asking for public disclosure of the borrower’s short positions.
And none of the curbs, be it on naked short sales or borrowed short sales, will be of any help if investors actually sell the shares owned by them. And during crises, investors just want to sell and get out even if they are incurring huge losses on those transactions.

One of the obvious drawbacks of a ban on short sale is that it reduces liquidity in a stock. More the liquidity, better is the price discovery. Besides, short sellers provide a floor for the stock price as they will be buyers at lower levels when it is time for them to square off their positions.

In India, individual investors are allowed to net off their trades on the same day. That is, a retail or high networth investor can buy 1000 shares of ACC and sell them, or a reverse transaction, the same trading day. But institutional investors—domestic and foreign—are forbidden from netting off their trades intra-day.

Naked short selling was rampant in India during five-day settlement cycles on the BSE and NSE in the 90s and early ‘00s. It is not as prevalent now for two reasons: one, shorter settlement cycle; the shares have to be delivered the following day. Two, local traders have been completely marginalized by foreign institutional investors.

Ban on short sales in India
In the past, SEBI has banned short sales on two occasions, without much success.
The first time the regulator took such a drastic step was in 1998. The 30-share Sensex had dropped 26% from April 21 to mid-June, the fall being aggravated by India’s decision to carry out nuclear tests in Pokhran.

SEBI banned short selling effective from June 17, hoping to arrest the slide in share prices. On the first day of the ban, the Sensex surged nearly 8% to close at 3400. But over the next five trading sessions, the index fell 11.7%. Foreign institutional investors, worried about US trade sanctions following the nuclear tests, continued to dump shares, rendering the short sale ban ineffective.

The next time SEBI did that was in 2001. The stock market was reeling under the impact of the global technology bubble burst, and back home, rapid unwinding of excess speculative positions was accelerating the fall. After the Sensex dropped 10% between mid-February and early March, SEBI banned short sales effective from March 8. The ban stayed in effect for nearly four months till July 2, but the Sensex declined 15% during this period.

During the global financial markets crisis of 2008, SEBI refrained from an outright ban on short sales, even though its counterparts in the US and UK introduced a selective ban. Instead, SEBI banned short sales by foreign funds, which were borrowing the shares for a fee from the participatory note accounts of foreign broking firms, and then dumping them in the market. This move too did not help much in the face of genuine selling by many foreign funds, anxious to cut their losses in a sliding market.

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