The practice of selling shares short in expectation of a price fall has come under suspicion in recent weeks. Some investors, it is suggested, have started vicious rumours about a company whose shares they have sold short in order to drive down the share price and reap big profits.
The attempt on HBOS, one of the UK’s biggest banks, earlier this month stung the Financial Services Authority, the UK regulator, into announcing an investigation into potential market manipulation. HBOS shares fell 17 per cent in early trading on March 19 amid speculation that it had sought emergency funding from the Bank of England.
Sally Dewar, managing director, wholesale and institutional markets at the FSA, said: “We will not tolerate market participants taking advantage of the current market conditions to commit abuse by spreading false rumours and dealing on the back of them.” The Securities and Exchange Commission in the US also reminded market participants of the repercussions of manipulating markets following the collapse of Bear Stearns.
Last week, the UK chancellor, Alistair Darling, said he would give the FSA new US-style plea-bargaining powers to clamp down on market manipulation.
Some commentators have questioned why the authorities are taking a tougher line on market manipulation that involves trashing companies to push down their share price than on the practice of ramping shares to drive prices up. There was plenty of that going on in the dotcom boom at the turn of the century.
The FSA in fact issued several warnings in 1999 and 2000 to investors of the dangers of share ramping via internet chat rooms. It said share trading firms should monitor chat rooms “for unauthorised investment advice, or share ramping through suggestions or gossip”.
But it was not until mid-2001 that the Financial Services and Markets Act subjected all market players to the same regime for dealing with market abuse.
It could also be argued that ramping may result in losses to investors but does not threaten financial stability. Putting a big bank at risk through the circulation of false rumours is a different game altogether. There are some concerns that the HBOS experience could lead to restraints on short selling, just as it is becoming accepted as a mainstream investment technique. Shorting has always had critics and still scares many investors, but the rise of 130/30 funds, which go 30 per cent short and 130 per cent long and are offered by well-known fund management houses, has put shorting on the map for an increasing number of institutional investors.
The increasing use of the flexibility allowed under Ucits III regulations has also seen more managers making use of both shorting and gearing in some funds.
Simon Fraser, president of institutional business at Fidelity International, says short selling, like other investment techniques, can be dangerous if used improperly, but is a useful tool if correctly employed.
“It is being more widely used so we need to ensure there are the right rules and regulations around it,” he says. He suggests additional transparency would help police the use of shorting, but does not expect the shock of the HBOS experience will lead regulators to curtail its use in regulated funds.
Short selling makes markets more efficient, he maintains, a view widely shared by academics. But in the current market turmoil “maybe it is being abused, and we need to make sure it is stamped out”.
He does not believe all fund managers should be free to short sell. It requires different skills than traditional long-only investing. “You need to understand timing, volatility and the cost of borrowing stock. The risks are definitely greater, so you shouldn’t make it available to all managers.”
At Fidelity, shorting is only allowed in products deliberately designed to be higher risk, and targeted at sophisticated investors. The experience so far is that the higher risk has been converted to higher return, says Mr Fraser.
Fidelity is probably regarded as a conservative fund house. It does not rush into hot investment areas, and has been cautious with new investment tools. That must be the right way to proceed. Make sure you know what you are doing should be the cardinal rule for all players in financial markets.
Simon Fraser discusses the issue of short selling in FTfm’s regular video interview at www.ft.com/ftvideo
is the editor of FTfm