Key Points
- ASIC recently banned both naked and covered short selling in the Australian markets, with covered short selling expected to resume later this year for non-financial stocks and next year for financial stocks
- Market participants have raised concerns that the ban has adversely impacted liquidity in the markets and as a result volatility has increased
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Introduction
On 19 September 2008, ASIC announced a ban on naked short sales on any ASX-listed stocks. This was followed up on 21 September with a ban on all covered short sales on ASX-listed stocks (subject to some exceptions).
ASIC’s prohibition followed similar actions by US and European regulators. However, ASIC’s prohibition went further than those imposed in other jurisdictions, which prevented only short selling of financial stocks (i.e. stocks in banks and other financial institutions).
The Australian ban on covered short selling was initially to operate for a limited 30-day period. However, on 21 October 2008, ASIC announced that it would continue the ban on covered short selling of non-financial stocks until at least 18 November 2008 and of financial stocks until 27 January 2009. The ban on naked short selling will continue indefinitely.
There has been extensive discussion regarding the impact of the ban, although this has been difficult to measure given market conditions. Questions have been raised as to whether the ban has adversely impacted liquidity and price discovery in the market. These in turn have indirectly impacted the market environment in which Australian M&A activity occurs.
Background to concerns regarding short selling
Short selling hit the headlines recently following reported practices of large hedge funds targeting specific companies (often highly leveraged), taking a short position on their stock and attempting to drive down their stock price, enabling the funds to make huge profits.
For example, if a company’s facility agreements had some trigger that enabled its financiers to review the terms of the facility, such as a market capitalisation threshold, the hedge funds would use an aggressive short position to drive the stock down to that level. The obvious effect of approaching that threshold was to remove investor support for the companies, especially institutional investors, and thus further reduce the stock price.
Victims of these short selling tactics have included companies such as Centro, ABC Learning, Babcock & Brown and, more recently, Macquarie Bank. Following ASIC’s ban, several of the targeted companies received an immediate boost to their stock price.
Details of the ban
ASIC initially banned only naked short selling (short selling in which the seller books the trade before it has borrowed the securities) and narrowed the permitted class of covered short selling (short selling in which the seller borrows the securities before it books the trade). It also required disclosure of covered short sales.
However, after monitoring moves by other international regulators and markets, ASIC considered that ‘the risk of unwarranted activity of the Australian market [had] intensified’, a risk ASIC said it had assessed ‘in the context of the small size, relative to other markets, of the Australian market and the structure of our market’.
Accordingly, ASIC decided to impose a temporary ban on all short selling of ASX securities, with limited exemptions for covered short selling activities which were considered appropriate to continue, including:
- arbitrage transactions involving dual-listed securities;
- sales resulting from the exercise of any exchange-traded options;
- specific relief for index arbitrage transactions deemed unlikely to be a mechanism for market abuse, and
- specific relief for short sales to manage the risk of underwriting dividend reinvestment plans, share purchase plans and convertible bonds and hybrids.
There was some confusion about the scope of the exemptions, which led the ASX to postpone the open of trading for an hour the day after ASIC announced the ban.
In its announcement extending the ban, ASIC stated that the fragility of financial markets warranted reopening covered short sales by stages while the various government interventions work their way through the financial system.
The Corporations Act already provides that a person can only sell financial products if they have, at the time of sale, a presently exercisable and unconditional right to vest the products in the buyer (or, at least, reasonably believes that it has such a right). The ban has been implemented by:
- ASX removing all stocks from ASX’s Approved Products List for short sales, and
- ASIC clarifying (through a class order) that a ‘presently exercisable, and unconditional’ right does not include a right under a ‘securities lending arrangement’.
Impact of the ban
Given the unprecedented market conditions that have subsisted during the period of the ban, it has been difficult to accurately assess its impact.
However, a number of concerns have been raised by market participants and commentators.
Short selling is now seen by many as an essential part of investment and risk management, and it has become commonplace in the market. There are many long-short funds, whose activities in the market have been essentially wiped out by the ban. Many traders consider that the ban has significantly, and negatively, impacted market liquidity as a result. Since the ban, commentators have pointed to periods of lower trading volumes, and a resulting increase in volatility, which accentuated the dramatic fluctuations in the market. Evidence in the United States similarly suggested a fall in liquidity during the financial stocks ban imposed by the SEC.
Concerns were also raised that the ban has distorted the market’s ability to price listed stocks. Efficient price discovery is a major argument in favour of short selling. There is, the argument goes, the possibility that banning short selling in the longer term will result in unduly inflated stock prices that will only be corrected by another dramatic market tumble.
Both of the above problems appear to have been compounded by hedge funds being hit by redemptions. ASIC has repeatedly emphasised that the ban is only temporary, but the expected length of the ban will be a long time for hedge funds, as they are forced to sell assets to meet redemptions and repay their debts.
Importantly, the ban and related actions by regulators may have contributed to a misleading perception that short selling is one of the primary causes of the current global financial crisis. When the US ban was lifted on 9 October, financial stocks were 23 per cent lower than when the ban was imposed, demonstrating perhaps that short selling was not as detrimental as the regulators thought. Similarly, the All Ordinaries has fallen 25 per cent since ASIC imposed its ban on 22 September. While predatory short selling may have had adverse consequences for targeted companies, some commentators argue that banning short selling will have no meaningful impact in reversing the current financial market concerns and may instead remove significant benefits to the markets in the form of liquidity.
New disclosure regime for short selling
The Federal Government has released an exposure draft of short selling disclosure legislation which will:
- require sellers to advise their Australian Financial Services licensee when the sale is a covered short sale, and
- require the licensee to then disclose the covered short sale to the market operator.
The licensee must also disclose any principal covered short sales it makes to the market operator.
ASX published its position paper on the exposure draft, supporting the Government’s proposal for greater transparency of short selling and stock lending activities.
ASX noted in support of short selling that, when properly regulated, it can enhance market liquidity and price discovery. It described short selling as a legitimate activity ‘that facilitates a number of important strategies, such as market making, arbitrage and the underwriting of capital raisings’.
ASX believes that increased transparency will improve price discovery and the robustness of equity settlement, as well as reduce the potential for market abuse.
ASX’s support of short selling does not, however, extend to naked short selling, for which it suggests that the ban be continued.
In addition, ASIC has announced that, with ASX, it has developed arrangements to facilitate the disclosure and reporting of short sales to ASX when the ban is lifted. Initially, trading participants would be required to submit daily reports of all short sales to ASX, though ASX is modifying its systems to automate the receipt of that information.
ASX would use the information received to produce a daily report which will be released to the market showing, by security, the total volume and proportionate percentage of short sales on the previous day.
ASIC and ASX will use the information collected to help them to detect market manipulation—the kind of short selling they are concerned to eliminate.
Conclusion
The moves by the government towards increased market transparency and disclosure in relation to short selling seem justified. Certainly, strong arguments can be made against naked short selling and the tactics apparently employed by some hedge funds. But key questions remain as to whether the continued ban on covered short selling (even with exceptions) will have any meaningful benefit for Australian markets. Perhaps a more measured approach by regulators is needed for what is a widespread and, some argue, integral market practice. It is to be hoped that the disclosure and reporting arrangements proposed by ASIC and ASX have the desired effect of eliminating market manipulation while allowing legitimate short selling to continue.
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