Australia blows up the hedge funds

Australia's stunning ban on all short-selling is a revolution that will likely flow around the world in a series of dominoes from tomorrow.

The global hedge fund industry will effectively be shut down overnight.

The business of securities lending will also shut down.

The way that equities markets have operated for more than a decade will suddenly and fundamentally change from this weekend.

Once the US Securities and Exchange Commission (SEC) banned all short-selling of financial stocks on Friday – naked and covered – the Australian market was facing an impending tsunami of short-selling by hedge funds looking to lay off long positions and take leveraged bets on the downside.

France, Germany, Ireland, Switzerland, Canada, and the UK have followed the US in banning all short-selling of financial stocks. They had little choice. Asian markets will also have little choice but to follow Australia tomorrow in extending the ban to all stocks.

The danger inherent in being the only market in which the world's long-short hedge funds are allowed to operate is simply too great. It would be like being the only person with a bleeding cut swimming in shark-infested waters.

The members of the Australian Securities and Investments Commission (ASIC), led by chairman Tony d'Aloisio, have been meeting virtually all weekend to frame a response, and have been keeping the minister, Senator Nick Sherry, informed. He has supported, indeed applauded, ASIC's decision.

On Friday, ASIC had banned naked short-selling and said that covered short-selling had to be fully disclosed from now on. (Put simply, naked short-selling is where the seller has not borrowed securities before booking the trade; covered is where they have been borrowed).

As we have argued several times in Business Spectator, banning naked short-selling is easy and should have happened long ago. With T 3 (trade plus three days) settlement, the only way short-sellers can guarantee they will meet settlement is if the stock is borrowed, and the only way they can guarantee they will be able to borrow the stock is if they have already done so before putting in the sell order.

Following the US decisions, followed by the UK and the others, to ban naked and covered short-selling of financials, ASIC decided on Saturday that it must follow suit and also ban short-selling of banks and financials – especially after last week's action in Macquarie Bank, which had fluctuated by 50 per cent.

But as the weekend wore on, it became clear that by simply banning short-selling of financials, ASIC would be exposing the rest of the Australian market to an intolerable risk.

It was felt that the Australian sharemarket was too small – 1.4 per cent of the world markets – and that any sudden increase in short-selling of non-financial stocks by hedge funds looking for other equities to bet against would have a more dramatic impact on the market as a whole here than elsewhere.

The same will apply to many other markets, especially in Asia. And then as the available pool of shortable markets shrinks, all securities authorities will have to totally ban short-selling. It is inevitable that this total ban on all short-selling will spread around the world.

Whether you agree or disagree with short-selling in principle, the effect of today's decision will be unpredictable.

Stocks will probably rise dramatically tomorrow, as hedge funds cover their positions and a massive source of selling pressure is suddenly removed.

But what will happen to the hedge funds and, more importantly, to their lenders? There is every likelihood that a run on hedge funds will now take place as their investors realise they no longer have anything to offer that is different to long-only funds.

And will the ban on shorting produce an unsustainable spike that will lead to an even bigger crash later? The answer might well be yes.

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