When the US Securities and Exchange Commission took the unprecedented step of banning certain kinds of short selling for 30 days in July this year, it put every global regulator on notice to stop dithering and take action to tackle market manipulation.
The SEC’s 30-day emergency measure aims to make naked shorting harder by holding the brokers – or anyone involved in processing a short sale – responsible for any failure to deliver the borrowed shares within a mandated three-day period.
It is the biggest action taken by any regulator to control the controversial practice of naked short selling. Borrowed shares can be used to take long or short positions – that is, betting shares will rise or fall – or to manipulate voting at companies’ annual meetings. The transactions are exempt from capital gains tax. A fund that wants to engage in “short selling” borrows a share and then sells it in the hope of repaying the loan of the shares by buying them back cheaper at a later date. The practice can put downward pressure on shares, triggering margin calls for investors who have borrowed to buy stock and potentially driving shares even lower.
“Naked short selling” is the same as short selling but without actually borrowing shares, or ensuring that they can be borrowed. While there is no evidence of naked short selling in Australia, short selling has wreaked havoc on many companies on the ASX and increased the volatility and wild fluctuations in stocks.
The Financial Services Authority in Britain has moved to improve transparency in short selling on the London Stock Exchange. In China, the Securities Law prohibits the buying or selling of securities without transfer of ownership and in Japan, regulators introduced rules to curb short selling during its financial crisis.
In sharp contrast, the Australian Government has known about the problems with stock lending and short selling since February but has done little except launch a review, with an announcement expected in the second quarter of the year.
The problem starts and ends with the stocks that are lent out by our super funds to hedge funds. While the Australian equities market is a fraction of the size of other equity markets such as the NYSE and the LSE, the amount of hedge fund activity in Australia has been nothing short of staggering.
Data compiled by Spitalfields Advisors, a London-based firm specialising in securities lending, shows that more than $US1.4 trillion of equities worldwide are now on loan. And at least $200 US billion of that is in Australia, wildly out of proportion with the size of the Australian equity market.
Australia’s $1 trillion superannuation industry warehouses its shares with “custodian” companies, which often offer a discount for the service if the fund allows the stock to be lent to third parties – often hedge funds.
Australia has been an easy short. Hedge funds borrow stocks from our super funds to attack companies. They are doing it with ease because there is little buyer support in the market, little transparency on covered short selling, no capital gains tax and small fees charged on share lending.
There is no legislation in place that forces these hedge funds to disclose to the market any short sales if the stock they are using to short is borrowed.
Put simply, stock lending cannot be traced and the ASX has no idea what proportion of shares have been “lent” to traders to short stock.
When reports began circulating in January that hedge funds were borrowing shares from superannuation funds and using them to drive down prices, ASIC chairman Tony D’Aloisio dismissed suggestions there was a problem.
“We haven’t seen evidence that short selling in the traditional way is an issue here. Stock lending has been going on for some time and, in itself, does not raise issues,” D’Aloisio told a business seminar.
On the issue of covered short selling, the Australian Minister for Corporate Governance, Senator Nick Sherry, said the Government was taking action. “Treasury has been working closely with the sector to develop measures to enhance the transparency of covered short sales to the market. A number of measures are under active development, including a Corporations Amendment (Short Selling) Bill .”
But as Southern Cross Equities director Charlie Aitken said in a recent note: “The question I am asking myself is what per cent of that $US1.4 trillion of equities on loan worldwide to shorters are shorts in Australian equities? That is impossible to answer because the data for Australia isn’t available as the ASX only reports ‘uncovered shorts’. We are basically flying blind down here and the only way to judge the scale of shorts is via gut feel, screen reading and talking to prime brokers. My 16 years of trading, screen watching and talking to other market participants tell me shorts in Australian equities have never been larger. In fact, the last 400 points the ASX200 fell was almost exclusively driven by shorting in my opinion. ‘Short everything’ is now a very crowded trade.”