April 4, 2008
SHORT selling must be banned. It is irresolvably incompatible with the fundamental integrity of the market. It really is as simple as that.
I refer to real - or so-called "naked" - short selling. So-called "covered" short selling is an altogether both simpler and more complex matter.
"Covered" short selling goes to the sort of volatility and transparency and possible malpractice issues that have battered a range of stocks over the past ten years or so. It also goes to the fiduciary duties and practices of fund managers and trustees.
It arguably isn't even short selling. More a contractual matter between the seller and the person from whom the seller has borrowed the stock. But with significant and reasonable disclosure issues for the ASX as the market.
In contrast, there is an absolute reason to ban "naked" short selling. It goes to the very basis of the market, any market: the certainty of delivery to the/any buyer.
Now the SEC has called for public consultation on the issue of short selling.
The very existence and timing of this call is both an embarrassment and a damning condemnation of the SEC.
Obviously damning as a regulator. The SEC is asking to be told how and indeed even whether to shut the stable door after the horses have long since bolted.
But also damning to the SEC as the market. It is only now recognising that it has been condoning a practice which is incompatible with the market's core integrity.
More correctly, half-recognising. It describes this fundamental incompatibility as "management of settlement risk". Further, it is yet to take even the first step to re-asserting that basic integrity with some form of interim set of rules. Sorry, to "manage the risk".
Naked short selling is where you sell stock you do not own and have not borrowed from someone - usually the trustee of some form of managed fund - so that you can deliver to the buyer.
That makes covered selling indistinguishable from normal selling. The buyer gets the stock. The "difference" is that the seller has to buy it back in order to return it to the lender.
But that is a matter between borrower and lender. In the narrow, it has nothing to do with the buyer or even the market. It's a normal sale. While the lender might not intend to sell, he is prepared to lend the stock to someone who does sell.
But with naked selling, unless the seller buys back on the same day, he is deliberately embarking on a course that will make him unable to deliver the stock he has sold in the required T(transaction)+3 days.
There are no ifs, no buts. If you naked sell on the Monday and do not buy back, you cannot deliver on the Thursday. Even if you buy back first thing on the Tuesday, that stock will only get to you on Friday.
So what has SEC got to say about this? Absolutely nothing. There is nothing in the SEC market rules to even recognise, far less establish a process to balance, short selling with the T+3 obligation.
And it is still not proposing to do so. For the obvious reasons, of course, that it can't. It argues that 99 per cent of trades are settled by T+3 and the remainder are "usually" completed EVENTUALLY.
But nothing, nothing on the core issue. If you allow naked short selling, you are condoning a priori breach of the fundamental market rule. Delivery in T+3. Indeed, the SEC seems to want to pretend the incompatibility doesn't exist.
There is only one way to resolve the incompatibility. For the SEC to itself guarantee delivery in T+3. To provide the stock, if the seller doesn't. I doubt, I know, the SEC doesn't want to go there.
There is a halfway house compromise. To specifically change the delivery time-frame for naked short selling. Making it say T+5 or T+8. With hefty penalties for failure to disclose and deliver.
That would have some pluses. It would better force seller and broker to abide by the rules and disclosure. But it would introduce a two-tier delivery structure for buyers. And one presumably without the knowledge of the buyer.
You buy some shares and suddenly you find they won't be delivered in three days but in, say, eight. In a high-turnover volatile market that could produce some very "interesting" flow-on effects.
So you come back to the core issue. It seems to me fundamentally incompatible with the concept of a market and the certainty of delivery, that you can allow someone to sell something into that market that they do not own.
It also reflects a peculiarly 20th century ineptitude. There is no need in a market sense for physical short selling when you could do everything with synthetics.
With one absolutely key difference. In the derivative market, you can use physical or cash delivery.
As for covered short selling, the main issue is with the appropriateness of trustees of funds lending out stock at very tiny fees.
The rationalisation is that this adds liquidity. That is certainly true. And that income can be earned on otherwise long-term dormant stock. That is certainly not true.
Not when you properly account risk. The risk of what it does to the value of the holding. And the counterparty risk. You mightn't get your stock back.
That part of the short-selling issue should take care of itself. I'd like to see a few trustees burned.
The SEC can, of course, require disclosure of such short selling under its rules. The SEC could, of course, have required such disclosure 10 years ago.
It was instead collectively asleep at the wheel, getting rich on more and more trades. Never mind where they came from.
The SEC is a failed regulator. It remains institutionally incapable of making itself functional. As a start the politicians must ban all (real) short selling.