Service on Finance and Development (Sept08/06)
Speculation via short selling blamed for financial turmoil
It is ironic that the huge Wall Street investment banks as well as commercial banks such as HBOS were among the victims of the speculators who used short selling not only to bet on a trend that the share prices of the companies would decline, but to influence and even help determine that trend.
On Friday (19 September), short selling in financial companies was temporarily banned by the US Securities and Exchange Commission. This followed a similar temporary prohibition of short selling on finance companies by the UK Financial Services Authority a day earlier.
The financial regulators have finally recognised how destabilising and dangerous short-selling can be and has been. The SEC chair Christopher Cox, announcing the ban, said the commission is "committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets." Earlier, he said the rules are needed "to ensure that hidden manipulation, illegal naked short selling or illegitimate trading tactics do not drive market behaviour and undermine confidence."
selling is now pin-pointed as the major cause of the drastic and dramatic
falls in the share prices of huge financial companies and banks including
Lehman Brothers (which collapsed last Sunday) and HBOS in the
The fall in their equity prices contributed to the substantial weakening of their market value and capital base, and thus threatening their viability.
The shares of the two remaining Wall Street investment banks, Morgan Stanley and Goldman Sachs, were also subjected to attacks by short-selling speculators. With their share prices dropping dramatically in the middle of this week, questions about their survival were being posed as well.
Short selling is a practice in which the speculator borrows the shares of a company and then sells them at the current price in the expectation that the share price will drop. The speculator then purchases the shares at the reduced price to deliver, and makes a profit.
In "naked short selling", shares are not even borrowed by the speculator, who sells shares that he neither owns nor has borrowed.
In selling large quantities of the shares of the targeted companies, the speculator in fact influences the prices of the shares to go down. Short selling can force share prices to fall below what is justifiable, and this destroys market and public confidence in a company which then faces collapse; without the short selling activity, it may have survived.
During the present crisis, as the shares of one big company after another have been targeted and fallen (leading to the demise of the companies or their rescue or take-over), regulators in the UK and US have finally recognised the manipulation involved and in the past few days proceeded to ban the practice, at least as applied to financial firms.
However, short selling is still allowed in other sectors. It is also so ingrained in the financial culture and system, under the belief that it aids "efficiency", that the authorities were careful to stress that the ban is only temporary.
During the Asian financial crisis a decade ago, the affected Asian governments blamed currency speculators (operating through hedge funds or through the currency operations of commercial banks and other financial institutions) for attacking their currencies through short selling and in doing so, bringing the rates of the local currencies far below their real economic levels.
At that time, Western governments and the IMF dismissed the claims of the Asian governments, arguing that their financial crisis was due to economic mismanagement and denying that speculation and the short-selling of currencies played any significant role.
Short-selling has continued and expanded as a routine and legitimate method of financial operation in the stock, commodity and currency markets.
The lack of regulation and accountability in the short-selling business was a major cause of the sudden drops in share prices and the solvency crises of the giant financial institutions that have shocked the world in the past week.
One major consequence of the crisis may be the re-examination of the short-selling method, and its regulation or even prohibition, at least in certain sectors and circumstances.
the global financial centres in
current crisis originating in the
However, in the incredible events of the past few weeks, which saw the pulling down of huge companies that are household names, the role of the old-fashioned but highly powerful and dangerous technique of short selling should not be under-estimated.
Monday (15 September), shares of the
In light of the market speculation, HBOS had to be saved from collapse through a takeover by Lloyds. The Liberal Democrat finance spokesman blamed hedge funds for speculating and called on the government to ban short selling of bank shares.
to the Guardian (
On 18 September, the UK Financial Services Authority announced a ban on short selling of financial stocks. From 23 September, investors are also required to disclose all net short positions in excess of 0.25% of a company's share capital. The FSA said it would extend the ban to other sectors if necessary.
Hector Sants, chief executive of FSA, said that it regarded short selling as still a legitimate technique in normal market conditions "but the current extreme circumstances have given rise to disorderly markets." As a result, it had taken the ban action to protect market integrity and guard against further instability.
If hedge funds and other investors were borrowing shares to "short sell", they were getting the shares from other investors and funds. The Financial Times reported that big US and European investors like the American pension funds Calstrs (California State Teachers Retirement System) and Calpers (California Public Employees Retirement System) and APG (Europe's largest pension fund) were among those who loaned out shares but they had stopped lending out shares of Goldman Sachs and Morgan Stanley.
A Calstrs spokesman said short selling was destroying the capital base of those two companies and stock lending was contributing to that.
The Lex column in the Financial Times (19 September) commented that the smashing of the world's largest insurer and the world's most prestigious investment banks were supposedly done by short sellers. "They short a bank stock, the price falls, the bank's credit is downgraded, forcing it to sell assets at firesale prices. This weakens its capital, the stock falls further, and so on. In practice, short-sellers are short anything with leverage. Yet by doing this they ultimately short themselves."
The New York State attorney general Andrew Cuomo, promising to investigate short selling abuses, said: "They are like looters after a hurricane. If you pass a rumour in a normal marketplace, people are calm, they check it out, they do their due diligence. When you get the market in this frenzied state and they are on pins and needles, any false information is much more impactful." (New York Times, 18 September).
With the two worst hit countries (the US and UK) taking action, it remains to be seen whether regulators in other countries, developed and developing, will also take similar action against short selling, including bans and disclosure requirements. +