Short Selling and Securities Lending in the Midst of Falling and Volatile Markets
University of Melbourne - Law School; Centre for International Finance and Regulation (CIFR)
July 5, 2010
Journal of International Banking Law and Regulation, Vol. 24, No. 1, 2009
U of Melbourne Legal Studies Research Paper No. 479
The phenomenon of short selling and the thorny issue of how best to regulate it are as old as stock markets themselves. Laws prohibiting short selling were first enacted in 1610 following a well co-ordinated and highly profitable 'bear raid' on the shares of the Dutch East India Company. This antagonism towards short selling was based on two beliefs - both of which are very much in evidence today as securities regulators and stock exchanges are once again confronting claims from many market participants that short selling exacerbates fluctuations in share prices and destroys investor confidence.
Short selling was seen then - and still is by many - as immoral. The short seller’s gain appeared to depend upon others suffering a loss, since a short sale of shares would only generate a profit if the shares declined in value. In addition, short positions and the need to cover them were thought to create a powerful incentive for the short seller to 'hedge' its risk by manipulating the price downwards - a view that was no doubt fuelled by revelations that the prime instigator of the short sale of Dutch East India Company shares was himself responsible for the major cause of the decline in the price of those shares (through his intrigues to establish a rival French East India company). The short sellers and their supporters countered unsuccessfully with two arguments: that the Dutch East India Company shares were overvalued (and, consequently, their short selling aided price discovery) and, more ingenuously, that the need to cover their naked short sales acted as a brake on the downward movement of the price of the shares. Then, as now, there was little sympathy for these arguments.
The debate on the merits and demerits of short selling has continued into the present. Moreover, because short selling, as it is commonly understood, involves selling shares in the expectation or hope that the shares can be subsequently bought back more cheaply, it is in times of falling stock markets that short selling attracts the attention of regulators, politicians and the investing public. The scrutiny to which short selling is now being subjected, in the midst of the current credit crisis, is hardly surprising, given that stock market downturns have routinely been followed by calls to ban short selling. This time round, regulators have been more receptive to these calls. In all of the three jurisdictions examined in this article - the United Kingdom, the United States and Australia - measures have recently been introduced to ban, in various degrees, short selling.
The short selling debate and the recent bans on short selling have been largely concerned with the perceived negative impact of short selling on share prices. The positive contributions of short selling to price discovery and market liquidity have been discounted by regulators confronted with falling markets, increases in price volatility and the erosion of investor confidence. The differences between naked short selling and covered short selling have also been discounted in that environment.
This article discusses the contemporary practice of borrowing shares for the purposes of short sales, as opposed to sourcing those shares in the open market for settlement after the sale order has been executed, and places that discussion in the context of the rapidly evolving regulation in the United Kingdom, the United States and Australia. Australia has been included due, in large part, to the recent case of Beconwood Securities Pty Ltd v. ANZ Banking Group Ltd7which decisively addresses the legal characterisation of loans of shares.
Number of Pages in PDF File: 13
Keywords: Australia, comparative law, financial regulation, securities markets, short selling, United States
JEL Classification: G00, G18, K00, K22, K39
Date posted: July 5, 2010