The ASX, Short Selling, And The Aussie Bond Comeback

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This story features ASX LIMITED, and other companies.
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The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The Australian Securities and Investment Commission (ASIC) again extended its ban in short-selling financial stocks this morning, at least until the end of May. The ban was originally put in place in September in concert with a knee-jerk reaction from ignorant regulators and self-interested politicians around the globe. The announcement came as the Australian Stock Exchange ((ASX)) revealed trading levels continued to weaken on the exchange in February.

Equities volumes were down again following a weak January, with the value of trades falling 46% from last February. Futures volumes were slightly higher than last month but still down 36% from a year ago. The fall in value reflects a combination of lower volumes but more so lower share prices. It is hardly a surprise that the ASX has railed against the short-selling ban – unsuccessfully it would seem.

Short-selling is a practice in which an investor sells a stock he doesn’t own, hoping to buy the stock back at a lower price down the track. A short-selling ban on financial stocks was initially implemented in the US last year following the fall of Lehman Bros in an attempt to prevent the collapse of other investment bank stocks. While Australia also allowed short-selling prior to the ban last year, there have always been significant differences between the two sets of rules.

In order to sell a stock short, an investor must first “borrow” that stock from another investor, most often a large fund manager, for a fee. However, in the US the concept of “first borrow” had become a vague one as lax policing of the rules from the regulators effectively allowed “naked” short-selling to thrive. “Naked” short-selling is the practice of selling a stock short and then buying it back in a relatively short space of time without having ever borrowed it. If the seller borrows the stock first as should be the case, it is known as a “covered” short sale. The US regulators further demonstrated their idiocy (and corruption?) in July 2007 by bowing to investment bank and hedge fund pressure to scrap the “uptick rule”. The US stock market collapsed shortly after.

The uptick rule dictates that an investor can only sell a stock short “on an uptick”. This means that the seller has to place an offer to sell above the last traded price and hope to be taken out by a buyer. A short seller cannot sell at the last traded price, and certainly not at a lower price.

While the US scrapped the uptick rule in 2007, Australia’s uptick rule remained in place. That is, until new legislation was rushed through last September. In cooperation with ASIC, the government introduced new laws which effectively tightened up short selling practices, ensuring only “covered” selling was allowed and full disclosure must be made. But as far as anyone can tell, the government made one startling error. It forgot to make any mention of the uptick rule in the new legislation, thus effectively scrapping it. At the same time it introduced the ban on all short-selling of financial stocks, other than exempt selling.

Exemptions are allowed for proprietary trades conducted by options market makers, for example, as these are an offsetting “hedge” trade.

The ban on short selling has been an amazing success – Australian bank stocks have done nothing but collapse ever since. Indeed, global bank stocks have done nothing but collapse. That’s why all around the globe short selling bans have now been lifted. They achieve nothing. What such bans do achieve is a reduction in liquidity and a subsequent increase in volatility.

But the Australian ban remains. In contrast, short-selling in all other sectors can be conducted on a downtick. Who was it that pushed hard for the uptick rule to disappear? The ASX.

The ASX argued that if covered short selling was properly regulated the uptick rule becomes redundant. This is rubbish. But is hardly a surprising claim from a company that both regulates trading on the exchange and profits from it. The ASX profits from the very volatility the regulators are attempting to control.

If the government had any sense it would immediately withdraw any regulatory power from the ASX.

And it would lift the short-selling ban, reinstate the uptick rule, and maintain regulations which prevent “naked” short-selling. You cannot force a stock price down if you can only sell at the offer. You can, however, conduct switch trades (buy one sector, sell another, for example) which provide much needed liquidity.

The ASX will not be happy about today’s announcement from ASIC. What it will be happy about, however, is an upcoming tenfold increase in government bond issuance.

The Australian government has issued few bonds over the last decade as it has had no need to raise funds. It was running a fiscal surplus all that time. A handful of bonds were issued simply to maintain some semblance of a market. But now that the government is spending big to reflate the economy, a fiscal deficit will ensue, requiring funding. That funding is sought by issuing bonds.

A revitalised government bond market will, in turn, reinvigorate a recently moribund bond futures market on the Sydney Futures Exchange, now a subsidiary of the ASX. A return to trading activity will help to offset lost volumes in equities and other derivatives.

Bond issuance is enough to encourage Macquarie, for one, to maintain an Outperform rating on the ASX. There are three Buy ratings in the ASX database from those who believe the stock has been sold down too far. There are five Holds, and one Sell from RBS (ABN Amro) who looks to ongoing volume and price weakness. The current average target price is $29.32.

For a last word on short selling, consider that Macquarie Group ((MQG)) shares were trading over $40 prior to the ban on financial short selling and have since traded at $15. One might look to the number of shares held on margin at much higher prices by Macquarie executives, all things being equal, before considering a short selling ban to be in any way effective. But such a ban is great politics.

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