Market controls: does intervention work?

Market interventions are all the rage these days. This should not be surprising; they always are in times of crisis. Politicians are invariably held to account by the media and electorate for inaction when the markets plunge, and they in turn pressure national regulators and central banks to implement any number of measures. Recent weeks and months have seen attempts to control currency markets, stimulus packages, and an attempt to crack down on that most dependable of scapegoats, short selling.

Short selling is consistently controversial. Its dubious reputation is longstanding, with attempts to control the practice dating back to at least 1610, when the Amsterdam Exchange introduced legislation controlling the activity following a formal complaint filed by an enraged Dutch East India Co accusing shorters of driving down its share price.

It has since been implicated in just about every crash and crisis from the South Sea Bubble of the 1720s to the Great Depression of the 1930s. It is hardly surprising then, that 2008 saw legislation of varying scope and severity outlawing the practice implemented across the globe.

Reckless money making?

The arguments for and against shorting are as old as the practice itself. "Bear attacks, which generally assume the form of short selling, have caused and continue to cause immeasurable damage to innocent stockholders,” said the original Dutch East India Co complaint. Even today, some feel that the potential for abuse by speculators, hell bent on reckless money making, means the risks are still too great.

“My concern is that people talk down the shares and buy them back cheap,” says Frank Field, a member of parliament for the UK’s Labour Party who tabled a 2009 private members bill in a bid to have the practice banned. “Action against short selling is not easy [because people need to hedge]... but we ought to recognise this blatant use of the rules to make mega fortunes and destabilise firms in the process as a serious evil that we need to tackle,” he continues.

The other end of the spectrum is typically occupied by hedge funds, which owe their existence, and name, to the ability to hedge against market risk via shorting. Here, any attempt to ban the practice as, Jiří Król, director of government and regulatory affairs with the Alternative Investment Management Association Limited (AIMA) puts it, is “the state infringing on property rights”.

Political ire

When markets are up, there tends to be relatively little opposition to covered short selling. Most Western regulatory bodies tend to subscribe broadly to the findings of an analysis of short-selling practices and regulations in 111 countries conducted by Hazem Daouk of Cornell University’s school of applied economics and management, which concluded that: “When short selling is possible, aggregate stock returns are less volatile and there is greater liquidity.”

In times of stress, however, short selling is invariably the subject of public and political ire. Former Enron CEO Jeffrey Skilling blamed investors circulating negative rumours about the energy giant for its 2001 demise.

More recently, former Lehman Brothers CEO Dick Fuld famously fingered short sellers and speculators as being responsible for the collapse of two of Wall Street’s most famous casualties. “The naked shorts and rumour mongers succeeded in bringing down Bear Stearns. And I believe that unsubstantiated rumours in the marketplace caused significant harm to Lehman Brothers,” he said in a prepared testimony to the US Congress.

Easy target

Blaming short sellers for Bear or Lehman’s demise may seem patently ridiculous, given that both were oozing rotten subprime assets and close to keeling over without any outside help. However, naked shorting has been recognised by many as a genuine concern and is currently banned in many territories. Even short selling’s most ardent advocates tend not to defend the practice.

“Naked shorts are against the rules, so there is no more to say about that. You should be able to borrow the security if you want to sell it short. If you cannot, you should not,” says Jim Chanos, president and founder of investment firm Kynikos Associates, a shorting specialist. Mr Chanos has made a career as Warren Buffet’s mirror image – taking large, long-term short positions – and even runs a website which compiles research and evidence championing shorting.

Now, attempts to crack down on the less dubious clothed variety – last fashionable in 2008 – are back in vogue thanks to August 12’s edicts issued by the Italian, French, Spanish and Belgian regulators, outlawing short-selling of financial sector stocks.

As before, these pronouncements arrived in the midst of a crisis. And as before, the rationale behind the recent bans appears to be no different to that cited in 2008 (or indeed 1610); cracking down on Mr Fuld’s "rumour mongers". According to a spokesperson for the European Securities and Markets Authority (ESMA), the decision to ban short selling was taken “either to restrict the benefits that can be achieved from spreading false rumours or to achieve a regulatory level playing field...”. The spokesperson adds that while markets are generally functioning well, there was “a risk that short selling was being used inappropriately”.

Manipulating markets

Here, as before then, the worry is securities fraud via (often rumour-led) share price manipulation. Most firms should be able to combat gossip-led price drops by simply demonstrating solvency, of course. But banks are arguably special cases. Any institution is runnable if enough people lose confidence.

The idea is still enough to spook bankers. Immediately prior to the implementation of recent European bans, a senior executive – who declined to be named – at one of the banks now the subject of a ban, voiced fears that a hedge fund with even comparatively modest resources would be able to destabilise a banking stock.

His concern was that due to a relative lack of liquidity in credit default swap (CDS) markets, spreads could be pushed out via a block purchase of as little as £20m ($31.4m). Wider spreads would indicate growing fears about the bank’s stability, in turn pushing down share prices and allowing the fund to profit from short positions. “Because CDS spreads are less liquid, [hedge funds] can then make a fortune by shorting the banks. The immediate impact on banks could be huge, as Lehman showed,” the executive said.

Blame game

The funds themselves have little patience for these claims: “The hedge fund industry is not nearly as big as people think we are,” says Stuart Kaswell, chief legal officer with hedge fund industry group the Managed Funds Association (MFA). “The assets managed by the whole industry are just over $2000bn. The concept that we can push CDS spreads out and then short them as part of some grand market manipulation is implausible.”

If, as the banking executive claims, it really only takes £20m to move a corporate’s CDS spread out, though, it may not be quite such a ridiculous notion.

There is, however, no proof of wrongdoing, and the regulatory record does seem to be on the shorters' side. Given the scale of concern, one might expect specific evidence of market manipulation to have cropped up since the widespread bans that were implemented in the midst of the crisis; thus far little has come to light.

“If those manipulative strategies were used, why have no regulators brought cases from 2008?” asks Andrew Shrimpton, a former alternative investors regulator at the UK’s Financial Services Authority (FSA). “There have been investigations into people supposedly spreading false rumours about banks and no cases were prosecuted. I was at the FSA, I supervised hedge funds and was involved in enforcement cases, and as far as I’m concerned the more effective approach would be to bring cases against anyone using those strategies.”

Lack of evidence 

There have been attempts. The FSA tried to prove that short sellers deliberately trashed stocks back in 2008, but subsequently abandoned the investigation due to a lack of evidence, although it clearly was not convinced there had been no wrongdoing.

"There is no doubt that false and damaging rumours were circulating about HBOS on March 19, 2008, and these would have had some impact on HBOS's share price. It is difficult, however, to say how much impact," the regulator said in a statement at the time, adding that it had “not uncovered evidence that they were spread as part of a concerted attempt by individuals to profit by manipulating the share price".

In the US, fruitless investigations followed the Bear and Lehman collapses too. And the lack of convictions was not a result of a lack of effort, says one hedge fund. “They subpoenaed everybody and everything, all the trading records, all the e-mails and instant messages. We had to present it all,” he says.

The evidence suggest shorters may not have been a problem this time round either. Information from securities financing data provider Data Explorers shows that the average percentage of shares on loan for the protected firms is in fact below the market average in France, Spain and Belgium, and has been throughout 2011. This implies that investors who have been offloading stock are long-only, and that they are jumping ship for their own reasons.

Hurting hedges

Unsurprisingly, addressing specific criminality by cracking down on an entire section in the market is not a strategy popular with hedge funds themselves. The MFA estimates that 70% of the 9500-plus hedge funds currently in operation will have their day-to-day operations and trading strategies constrained by the ban.

The effects of a ban on a typical long/short equity fund are obvious, and convertible arbitrage is an impossibility without shorting, but risk arbitrage strategies will probably also be impacted, as the fund would likely hedge by taking a negative view on another company in the sector.

Despite bitter complaints, however, hedge funds are unlikely to garner much popular or political sympathy. And in any case, if banning short selling removes even a small possibility of market abuse and stops a systemically important bank from going under, might it not be worth the penalties imposed on the rest of the market?

Perhaps, but that relies on the bans actually being effective. The evidence appears to suggest that legions of rumour-spreading shorters are not, in actual fact, laying siege to the world’s financial institutions, but the recent European bans did at least herald a short-term rally in European banking stocks. For Pascal Canfin, member of the European Parliament and rapporteur for regulation on short selling, even this modest recovery counts as a success of sorts. “In an emergency situation, taking this decision lowered the pressure in the following days,” he says. “It was necessary."

Minimum impact

The slide was hardly averted however. Since the bans were enacted, Société Générale has seen its share price drop from €24.30 on August 12 down to just €14.31 a month later (its 2011 high was €52.70). SocGen has suffered more than most – it was forced to issue a release denying it was in trouble after UK newspaper the Mail on Sunday published a (now retracted) article suggesting the French giant was on the verge of collapse.

Its peers suffered too; the STOXX Europe 600 banking index, which stood at 149.08 when the bans were introduced, sunk to 120.86 on September 12, the lowest mark since early 2009.

Whether short-selling bans were actually the cause of any short-term recoveries in share prices is debatable, given that briefly the financial sector was up as a whole. Barclays, the Royal Bank of Scotland, Deutsche Bank and Commerzbank – none of which were the subject of bans – also experienced an increase in share price.

Previous bans appeared to have a similar lack of long-term effect on pricing. In their paper 'Short-Selling Bans around the World: Evidence from the 2007-09 Crisis', the University of Amsterdam’s Alessandro Beber and the Università di Napoli Federico II's Marco Pagano argue that while the share price of US financials may have been supported by the Securities and Exchange Commission's (SEC's) 2008 ban, it is far more likely that the Troubled Asset Relief Program announcement was the main reason for recovery.

In any case, in the three weeks the ban was announced, shares in banks, brokerages and insurers lost a quarter of their value, leaving SEC head Christopher Cox’s promise that "the emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets", ringing slightly hollow. Mr Cox has since said the ban was one of the biggest mistakes of his tenure at the commission.

More harm than good

There is, of course, no way of telling what might have happened had the bans not been enacted, points out Mr Daouk, the Cornell academic. “Some might argue it has not been effective because prices have continued to go down, but to truly make that call, you have to be able to say what would have happened if it had not been in place,” he says. “Perhaps things could have been much worse, there might have been a market breakdown or downward spiral.”

Potentially ineffective policy seems almost excusable in the midst of a crisis and 'better safe than sorry' is arguably a reasonable regulatory mantra when markets are crashing. It certainly appears to have been the reasoning this time round.

“The bans have to be considered as a preventative measure to fight speculation against banking shares,” says a spokesperson for FMSA, the Belgian regulator. “It was taken at a time when a lot of unfounded rumours were circulating about the French banks. Our view was that it was better to extend the existing ban on naked short selling to covered short selling. We took responsibility at the time, and that’s our job as a supervising authority."

Implementing ineffective regulation based on flimsy evidence is one thing, but some argue that, more worryingly, bans may in fact harm the stocks they are intended to protect. Not least by indicating to a skittish market, precisely which firms they should be concerned about. According to Mr Chanos, the SEC’s emergency ban on July of 2008 was effectively a list of 19 banks which might be worth selling. “They put up a target list for people," he says.

Unintended consequence 

A study conducted by Richard Payne – a reader in finance with London’s Cass Business School – and his colleague Ian Marsh found that UK bans on short-selling financial institution stocks imposed from late 2008 to early 2009 in reaction to the crisis did not reduce the haste with which financial stocks were sold off. Instead, trading volume in financials evaporated and order book liquidity was dented. And a shallower order book meant that any downward pressure, even from conventional long-only investors, was amplified.

Similarly, losing the ability to short will make it less likely for long/short hedge funds to actually buy these stocks as they will be unable to hedge. Counter-intuitively, banning shorting could push the price of financials lower than they would otherwise be. “All the evidence suggests bans are a bad idea, they make markets harder places and more expensive to trade [in],” says Mr Payne.

Prohibiting short selling also relies on the assumption that every shorter is a Mr Chanos – taking large, long-term short positions – when a large amount of short selling involves financial services firms hedging off non-marketable exposures to each other.

An inability to do so could well invoke the great law of unintended consequences once again. Bank A might keep an interbank line open to Bank B, and keep rolling overnight debt, so long as it can hedge some of its exposure through shorting Bank B, but if a ban means it cannot do so, then that line may well be closed, exacerbating funding problems.

Erratic implementation

Moreover, the manner in which the European bans have been implemented might have proven somewhat counterproductive. The speed with which they were sprung on the market and the apparent lack of harmony amongst ESMA member states led some to sniff out a whiff of something closely resembling panic. 

“It didn't feel like the content and the application of the bans were coordinated. Some important clarifications were missing, making it extremely difficult to understand how to ensure compliance,” says AIMA’s Mr Król. “Although we continue to strongly oppose the imposition of bans, we understand the pressure under which the regulators operate and are working with them to improve the legal context and certainty around any potential future restrictions."

Certainly, the bans were announced and applied swiftly, and while they were more closely standardised than 2008’s fragmented responses, there were still some significant differences. Moreover, Germany’s refusal to extend its long-standing short-selling restrictions, along with the UK and the Netherlands' rejection of any such action, is far from ESMA’s harmonised goal. “This kind of decision needs more coordination between regulators,” says the European Parliament’s Mr Canfin. “We would like to see a more harmonised approach.”

Finding a way

Action or no, bearish traders with an eye for money making will likely find a way to be bearish, resorting to synthetic stock equivalents or the CDS markets, for example. Market makers will find it particularly easy to circumvent restrictions, says one former desk head with a major European bank, who declined to be named.

It might even be easier for a large financial institution, they add – if a derivatives desk is long on shares due to options strategies or structures, cash equities desks could go in short so long as the bank was flat overall. 

The idea that free markets will always find a way is contentious, but if past performance is any guarantee of future returns, regulators might want to invest their time elsewhere. Even extreme measures are often largely ineffective; Hong Kong’s stock and futures markets closed for a week following 1987’s Black Monday and shutting down trading following precipitous drops was routine in Russian markets for much of the 1990s, but negative price movement continued at the next available opportunity.

This looks likely to be repeated in Europe. Tinkering at the edge of the markets assumes an air of futility when viewed in light of the intensifying debt crisis, with regulators reduced to the role of a medieval doctor bleeding his patient.

Effective or otherwise, while there is political pressure for some measure of action, action will invariably be taken; and for hundreds of years, short selling has borne more than its fair share of the consequences. The issues and arguments are not new, but they will undoubtedly be debated for many years to come.