The ban of short selling in the US, UK and now Japan is a testament to the serious state of the financial markets and the real possibility, that a growing number of banking institutions are vulnerable to having their share price artificially depressed, by naked short selling by greedy traders. Although the ban ends in the UK on the 29^th January and is restricted to the 29 financial stocks the fact that this action has had to be taken demonstrates how serious the financial crisis has become. Banning short selling only ever happens when the authorities are unable to exert real influence and where the financial institutions are powerless to control the markets, as in 1929. 

The problem is not short selling itself, but that the immense growth of new financial instruments, like hedge funds, which are loosely regulated and not understood by either the financial institutions or the regulators and this free for all in the short selling market has been allowed to continue for years.

Hedge funds have sprung up unabated and produced increased volatility and risks, which have been converted into huge profits by those creating them and of course those backing them. All this at the expense of the innocent target company (This has been happening to many companies over the years not just Banks) unable to control any attack on its share value. This practice has never been illegal and to my mind never fully understood by those organisations supposed to be the protective bastions of the investor and the companies they invest in.

The trouble is you cannot have it both ways; a secure stable financial market that encourages long term investment and that of the Casino, for those looking to make fast bucks. For many investors playing the market they have enjoyed spectacular profits despite the effect of their dealings. Portraying an image of a few wealthy short sellers sitting back, gorged on their latest success, as the majority pick over the bones of the latest corporate carcass.

“You reap what you sow” currently, we are seeing the reality of the hazardous world of financial markets, where banks have made huge profits at the expense of many companies and their investors and now a whirlwind debt is devastating the banking system and its structures. Hence banks are now turning their attention on each other worried by the risks of lending, unsure the borrowers will be able to repay. Given banks are losing confidence in each other, it is not therefore surprising that investors are losing faith with the banks and the financial markets in general. Banks need to urgently act responsibly and sensibly and try ride out the present storm and the ban on short selling a temporary measure as it is one that has no long term benefit to the market or clients.

Short selling is not the cause of the current global crises but it is an unwelcome rouser of mob rule bringing down sound banking institutions that in the main have a good business. In another time the banks as a collective would have pulled together to support each other.

Today the fragmented nature of the markets and the unmeasured black hole of debt have created a “dog-eat-dog” situation where it will be the stability of the traditional banks operating in a traditional manner that will have the most fortitude. This is clearly evident with Lloyds TSB purchase of HBOS. A deal that would have been unthinkable a short time ago but the depressed share price of HBOS through short selling has helped created this opportunity. This is terrific for Lloyds TSB and its shareholders but less so for HBOS, its shareholders and the competiveness of the UK banking industry.    

Many years ago short selling was a vital part of the market in the UK, with any short position covered by borrowed stock from a highly regulated short list of Money brokers. These were closely monitored by the Bank of England who would scrutinize and then manage any dangerous positions by calling in the bank for a fireside chat. For some, the money brokers were a cartel and this was eventually opened up, allowing all and sundry to borrow and lend stock to cover short sales. This created the environment and opportunity for the creation of Derivative Instruments, which have grown to fashion the type of market we have today and the Bank of England was replaced by the FSA as regulator by the Government.

Now it is up to the FSA to ensure the quality of systems and people regulating the markets and to fully understand the nature of the business, which financial firms undertake as well as the shifting markets.

There is no doubt that the regulators should have seen the black hole being created by the wholesale use of short selling to produce a false market. A false market is bad enough but compounded many times over when short sales camouflage debt upon debt upon debt. Now the credit crunch has exposed the expanding universe of debt that has been building under the feet of the regulators. Like magma it was only a matter of time before the financial volcano exploded covering all and burning the banks, which have been exposed by their own greedy actions but made more vulnerable by the inability of the financial system and its regulators.

However, short selling is a vital aspect of financial markets providing liquidity and the ability of investors to enjoy that benefit. A market without short selling will eventually stagnate and reduce the potential for profit and loss and drive the investor to other types of market. So this ban should be short lived.

What is required however, is a much more stringent and controlled use of short selling, more regulation and also more control by the banks. All transactions in derivative instruments by any entity private or otherwise should be reported to any of the exchanges. This would bring about a more transparent market where potential systemic risks could be detected and remedial action taken by the regulators and the affected banks. Institutions providing naked shorts should be obliged to report them throughout the day on a mark to market basis; there should be a set time when the short position has to be covered by an equity transaction. Short positions should not be covered by yet another strategy that only utilises other derivatives to cover up the short.

Regulators need to fully understand the nature of the instruments and the business of the firms they regulate. 

There should be a regulatory accreditation of the financial firm to ensure that they have the systems and procedures already in place before they take part. This must include board monitoring capability and established lines of responsibility. Hedge funds and any other entity or individual trading over a certain size must be regulated. The free for all has to stop!

Investors will only regain confidence if they see the financial markets taking action in both the short and long term, to ensure we never again see this panic and uncertainty in our markets.

Most importantly the banks need to be sure that all banks within the financial system are vigorously regulated and that levels of debt are covered by top quality assets on the balance sheet so that there is not chance that any debt is masked by derivatives and short selling producing an artificial picture of the sustainability of their business.

So to sum up “short selling is not the cause of the current situation”! The main reason is the lack of confidence by banks in banks, which was created in the sub prime market in the USA. However, because of the globalisation of the financial markets the credit crisis has rapidly spread throughout the world.

The incalculable short selling positions and the ability of short sellers to manipulate the market and accelerate the decline of banks significantly has undermined the financial markets and produced high panic. From this blind panic small numbers of people make fortunes at the expense of the many. The regulators have failed 100% to provide the financial markets and its investors with any security and that has brought uncertainty, fear and almost the total disintegration of the financial system.

Short selling should to be brought back in the UK on the 29^th January but hopefully sooner if possible. However, under a new set of rules where the regulators can monitor and control misuse. Until then we are all in an extremely vulnerable space. I truly hope that no more of the banks disappear although it has to be said they have been a significant factor in their own demise.        

By Gary Wright