Australia | Mar 06 2009
By Greg Peel
Just as I assumed, I have been bombarded with emails regarding the views offered in yesterday’s article “The ASX, Short Selling, And The Aussie Bond Comeback”. Rather than reply directly to them all, or any more coming, and to address silently disquieted readers, I have published below two such letters and my responses to them. I use only the first names of the correspondents so as to respect their privacy and not single anyone out.
From Bryan:
“I read with interest your article on Short Selling today.
“It is difficult for me to accept that short selling is anything other than market manipulation at the expense of genuine retail investors.
“The shorters justify their activities with the claim that short selling creates liquidity and assists in price discovery. These are spurious claims and the only beneficiaries of the “liquidity” seem to be:
- the ASX, brokers and stock lenders who earn commission and fees, and of course
- the shorters who have the use of the proceeds of their sales until such time as they decide to buy back in.
“As far as price discovery is concerned this is nonsense as the shorters can create an artificial oversupply of stock and we all know what that does to the market.
“Stock lenders are the second string of culprits in the short selling exercise. They lend stock which has been entrusted to them by superannuation fund members, shareholders in LICs and insurance companies and beneficial owners of custodian companies and then sit back and watch while the short sellers depreciate the value of their clients’ assets.
“Ian Verrender wrote a very telling article in the SMH on 8 January titled “The regulators fiddled while we got burnt”. This was about a shorting exercise whereby an unidentified overseas hedge fund borrowed BNB shares from an unidentified fund manager in 2008 and sold them for approx $18, netting approx $400,000. They held the cash for a year and bought the shares back in January for about 40cents. Now we are all aware of the shortcomings of BNB but in my opinion the fund manager who lent those shares failed in his fiduciary responsibility to the underlying beneficiaries of those shares. If the fund manager had been competent it would have sold those shares for the benefit of his members in 2008 rather than lending approx $400,000 cash for twelve months culminating in a $390,000 profit to the hedge fund.
“The fact that short selling has been a market practice “forever” is no justification for its existence.
– What other market allows traders to sell tangible asset they don’t own?
– What other tangible asset can be “lent” without the beneficial owner’s permission to be sold by a third party?
– In what circumstances can these practices be other than market manipulation?
“It would be appreciated if you would explain to me how the practice of short selling a genuine benefit to retail investors.”
My response:
Firstly, let me draw upon two letters to said SMH which I read yesterday, and with which I concur:
“Any discussion about short selling inevitably throws out the canard that selling something you don’t posses is fraud in any other market. When I pay for a year’s subscription to the Herald, is Fairfax committing fraud because it does not yet possess the issue for June 24 [I could include an FNArena subscription here]? No. If I buy vegetables on line and the retailer buys them the next day from the market and delivers them, is that fraud? No.
“As long as you deliver on your contract, there is no fraud. The same applies to short selling shares. That doesn’t mean short selling is a good or bad thing, it’s just not fraud.”
– Sean Carmody of Petersham
“Short sellers make money only if sellers at a later date are willing to sell them shares at a lower price to allow the short sellers to close out their positions and crystallise their profits. Over time, they are net neutral on share prices, as they both sell and buy shares.
“If in the short term the price is below its true value, that allows investors to buy quality shares at a great price. If prices are too high in the first place (as they have been over the past three years), short sellers serve a useful purpose in causing prices to normalise more quickly, so that fewer investors buy at inflated prices. If the Government wants to ensure Australians have adequate retirement savings, it is vital that superannuation funds do not buy shares at overvalued prices. Short selling creates a more efficient market. If it had been over the past few months, there would be fewer investors sitting on losses in shares such as Macquarie Bank and Commonwealth Bank.”
– Pete Hanich of Epping
To add to the last letter, note that no one ever became anxious about short selling in the five-year bull run. No one complains about anything when they are making money, only when they are losing it. Without short selling, the ASX 200 would likely have reached a much greater height than it did in 2007 and thus would have had much further to fall (even without short selling). The pain would be much greater right now.
Now – to address your specific questions:
What other market allows traders to sell tangible asset they don’t own?
Almost every mining company at some point forward-sells copper, gold, whatever, before it is mined. This serves two purposes: providing funding for the mining operation itself and locking in prices in a volatile market. Mining companies can get caught out if the reserves they thought were there when they sold forward actually are not.
The vast bulk of the world’s commodity trade involves futures markets, in which short selling is permitted (actually required) alongside buying. Perhaps you don’t call this “tangible”, but the underlying commodities are. If you are asked for delivery on expiry, you must provide it.
The same goes for options markets, including options on stocks. If you buy naked put options you are short-selling. If you sell naked call options you are short selling. The same is true for warrants, CFDs and other such derivatives. To ban all short selling would be to ban all derivatives markets and thus to remove the capacity to “hedge”.
You may have a similarly negative view about derivative markets Bryan, given abusive practices such as CDO creation constantly give such instruments a bad name. But to remove derivatives markets from the equation would be to shatter liquidity in any market, and enormously increase volatility.
In the case of the superannuation funds everyone is most concerned about, consider that when super funds make large portfolio adjustments, running into billions potentially, they often do so through proprietary market-makers (usually brokers) in off-market trades. While this might ring “transparency” bells, the reason for such off-market trades is simple. Super portfolio adjustments can be lumbering giants of trades. They have the capacity to substantially move a market at the expense of the superannuant given higher and higher (and on the sell side, lower and lower) prices would be achieved. The rest of the market steps aside once the word is out. As soon as the final high price is traded, the market would fall back immediately, ensuring superannuants have paid “top of the market”.
Proprietary market-makers take the other sides of these trades in one hit, pitching prices above the market (or below on the sell side). This is the premium for the risk the market-maker assumes, for the market-maker will then work those positions through the market over a period of time, more stealthily than the super fund ever could. Sometimes market-makers win, sometimes they lose, but the super fund has successfully transacted at an acceptable price. In order for super funds to buy from market-makers, market-makers must sell short for a period of time.
These are just some examples.
What other tangible asset can be “lent” without the beneficial owner’s permission to be sold by a third party?
The cash you deposit in a bank.
In what circumstances can these practices be other than market manipulation?
All of the above, and many more.
I can understand why retail investors have become incensed about short selling during the GFC. And indeed there are hedge funds and others out there who seek only to profit by “knocking down” a share price, the most blatant examples including B’n’B, where the sole intention was to trigger debt covenant breaches. But had this not occurred, B’n’B would still have been ultimately found out by the market. Short-sellers simply speed up the process.
On the other side of the coin, take your Macquarie Group example. The ten brokers and advisors within the FNArena database have currently set an average 12-month target price for the shares of $31.21 - some 70% above their current trading price. If MQG shares have been battered by short-selling, the brokers are trying to tell you what a great buying opportunity is being provided. Of course, financial stock short selling has been banned since September, but there are other ways and means to achieve the same result (some of which appear above). That’s another reason why a short-selling ban is ineffective.
I strongly believe that markets benefit over the longer term time frame from the capacity to short sell and the existence of derivative markets. That does not mean, however, I am anti-regulation. I strongly believe both should be sensibly regulated. In the former case, I believe regulations in place such the inability to “naked” short sell and full disclosure responsibilities are vital. I also believe that an uptick rule is also vital. The latter is not currently in place.
Just as a last point, while short selling gets all the coverage, I think you’d be surprised just what a small proportion of a year’s trading actually relates to this practice. As a retail investor, I’d be looking at margin lending abuse long before any short selling accusations. For some this would mean looking in the mirror.
From Wesley:
“Quite a good article, abolishing the uptick rule was criminal and allowed the carnage over the last 15 months to be worse than it otherwise would have been. The other criminal issue relating to short selling, which goes largely unnoticed and is not mentioned in your article either, is that Super Funds and other institutional custodians lend their shares out to hedge funds for a fee (actually these shares belong to mum and dad investors), who then sell the shares, forcing prices down and hurting the underlying long position of the mum and dad investor, without their knowledge or consent!?! Now that is the main abuse that is not reported on. The regulators just have no understanding of the real world marketplace. Reported, regulated and covered short selling can be allowed, but nothing else. Also, financials going down despite short selling ban does not mean ban itself was wrong, it’s simply instos and hedge funds shorting by other methods, derivatives etc, which was always going to happen but regulators wouldn’t have a clue.
My response:
Yes I did mention borrowing stock for a fee but no, I didn’t go into insto detail. One assumes that if a market were functioning efficiently, insto fees for borrowing would rise on such short-selling demand, to the point that the trade itself becomes less economical on a risk basis. However, as only 10% of a company can be shorted (I believe that’s right) there is no lack of supply of stock.
The irony is that while the instos receive a fee, which can only help their returns, the act of short-selling reduces those returns. There have been instances in the US of instos refusing to lend on certain stocks.
You are absolutely right about derivatives. If a hedge fund buys put options on financial stocks, it is the proprietary market maker who must then sell stock as a hedge. This practice is exempt from the ban. Just another reason to find such bans a misguided waste of effort.
But proprietary trading also involves such practices as portfolio market-making, in which an insto can make major portfolio changes in one hit, without having to push individual stocks or tip off the market. This requires stock borrowing from a prop desk – again exempt. If a regulator were to try to unravel all prop shorting with the intention of restricting some practices but not others, it would only be a nightmare.
All the more reason to just let the market operate as it should, albeit with a simple uptick rule in place.