In late 2008, as the global financial crisis enveloped markets, regulators around the world, including the Australian Securities and Investments Commission, took a highly contentious and controversial step and banned short-selling of shares on their markets.
Today ASIC released a report looking at the impact of the bans – permanent for "naked" short selling and temporary for "covered" short sales. Not surprisingly, it is inconclusive.
The decisions were controversial because there were many in the market that believed, and presumably still believe, quite correctly, that short selling adds liquidity to the market and aids price discovery.
There were also institutions – firms and fund managers that lend securities to facilitate short selling, custodians, brokers and fund managers pursuing long/short strategies – for whom the ban represented a cost and/or an opportunity cost.
On the other side of the debates were those who believed that allowing short selling during a period of near-unprecedented market volatility and fear would exacerbate the volatility and losses and add to the general climate of anxiety.
There were particular concerns about the impact of short selling on financial institutions and a legitimate fear that the short-selling might exaggerate price falls and cause depositors and lenders to take fright and destabilise otherwise stable organisations.
At the time there were also reports of "rumourtrage" – the spreading of negative rumours by short-sellers to drive down prices. At the time there were also reports, some based on fact, of key executives leveraged to their companies’ share prices through margin loans.
ASIC investigated many of the claimed rumourtrage reports without uncovering any major instances of improper behaviour, although it believes that the warnings it gave market participants about rumourtrage may have had an impact.
There was also the threat of arbitrage. Other major markets had introduced bans before ASIC and there was some concern that as a large and liquid market with integrity the ASX could attract short-sellers from those markets where the practice had been banned.
The ASIC report is inconclusive because it is impossible for it to determine what might have happened had it not implemented the bans. The market would in any outcome have been volatile, spreads between bids and offer prices would have blown out and there would have been steep falls in prices, particularly for leveraged organisations, anyway.
The ban on short-selling may have amplified all those factors, and probably did. Given that markets were volatile and share prices globally were plummeting as the global financial system teetered on the brink of implosion it isn’t, however, possible to separate the impact of the ban from the general market circumstance.
ASIC, however, believes that taking into account the particular environment at the time the bans were introduced the benefits outweighed the costs. It also believes that should a similar situation arise in future that involved disorderly selling and action by regulators in other jurisdictions it was likely that it, and the government of the day, would again contemplate a ban on short-selling to bolster investor confidence and limit the potential for international regulatory arbitrage.
It also, however, acknowledged that the regime has changed. There is a new disclosure framework for covered short sales and short positions and a permanent ban on naked short selling (selling shares without an arrangement to borrow them) which ASIC says may limit the need for a total ban in future periods of market turmoil.
ASIC left its bans on short-selling of financials in place after some other regulators had lifted theirs, partly because of the unusually central role the banks in particular play in this financial system and economy.
In the circumstances the bans were defensible. Financial markets post-Lehman Bros were fragile and vulnerable and regulators acted reasonably in adopting a "safety-first" mentality and avoid the risk that short-selling would trigger panic and damage to the system that might otherwise be avoided.
Whether the bans helped or hindered the workings of the market will never be known. In extreme circumstances like those experienced in 2008 it is better to be safe than sorry.
Hopefully, however, with naked short-selling banned and far better disclosure of covered shorts, the market will be allowed to function freely unless equally dire and uncertain circumstances arise again.
Even then one suspects the authorities would, with the possible exception of financials, be slightly more reluctant to intervene than they were in 2008 now that they’ve been able to see what happens to liquidity, spreads, volatility and trading volumes when short selling is prohibited at a moment of market crisis.
ASIC's short-sell ban uncertainty
ASIC has declared its post-GFC short-selling ban to have been a costly but effective measure. But given the effect on liquidity, spreads, volatility and volumes the regulator may be reluctant to go there again.
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