Some believe speculators are restless egoists who create financial crises. Others see them as part of a healthy market ecology. This week they fell into the first camp. Both the UK and the US banned shorting of financial companies. Russia, meanwhile, stopped short sales on all stocks. But what should be done when these temporary bans end?
Short-sellers perform a vital function. By bringing market prices in line with an asset’s true worth, they provide a mechanism for price discovery. Yet last week short-sellers morphed into price creators. It is one thing to short China’s ICBC, believing it to be overvalued at three times book value. It is another to short HBOS when it is trading at 0.5 times. The first is an opinion; the second equivalent to inciting a bank run. Some argue short positions were too small to make much difference; only 3 per cent of Morgan Stanley’s shares were on loan this week. Yet the inherent leverage of bank balance sheets amplifies small positions.
One reform, already enacted in the US, is to insist short-sellers borrow shares before putting on a trade – that is, no “naked” shorting. Short-selling could also be permitted only after an uptick in a share. That would stop investors kicking a stock when it is down. As the rule was suspended in the US last July, it could easily be brought back. A more radical option would be an automatic ban triggered during moments of systemic distress, perhaps when a bank’s price-to-book value fell below, say, 0.6 times, the average trough of past crises.
Of course, banks do not have to be listed to go bankrupt. Nor were shorts the only – or even the biggest – villains of the past week. Bank of America is reported to have cut Merrill Lynch’s trading lines days, albeit temporarily, before it bought the broker. Most bears look cuddly compared to such ruthlessness.
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