Published October 9, 2008

SGX has the right approach to short-selling

By R SIVANITHY
SENIOR CORRESPONDENT
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NEWS that the ban on naked short-selling in the US stock market will be lifted with effect from yesterday will surely be greeted with relief by many quarters of the financial community, and the move should, hopefully, be followed by all other markets which were too overly eager to follow the United States' example over a fortnight ago.

This is because the Sept 19 ban was ill-conceived in the first place, serving little purpose other than to tell the market that regulators had run out of ideas of how to prop up sagging markets and were in panic mode.

Instead of having the desired effect of halting the bleeding, it ended up robbing markets of liquidity, efficient price discovery and possibly even support that the ban was intended to achieve.

Take for example the fate of Wall Street. The ban kicked in when the Dow Jones Industrial Average stood at 11,388 and the S&P 500 was at 1,255. After Tuesday's collapse and after 11 trading days with the ban in place, the Dow was at 9,447 for a loss of 1,941 points or 17 per cent, while the S&P at 996 has suffered a loss of 259 points or 20 per cent.

The story is the same elsewhere - the UK market, for example, has lost more than 15 per cent since banning shorting while similar losses have been encountered across Europe.

Here's a thought: Could banning shorting actually have worsened the downside?

Possibly - observers have noted a spike-up in volume in futures markets worldwide since Sept 19 because short-sellers, unable to trade in the underlying markets, probably turned their energies to the futures markets instead. And, as most market watchers know, steep falls in futures contracts could, in turn, have placed undue pressure on the spot markets, thus driving prices in the latter down.

Whatever the case, it is illogical to temporarily interfere with the workings in any market or, as some have described it, to shift the goalposts after the game has started, especially if there is an associated derivatives market.

Both depend on each other to properly reflect prevailing sentiment and expectations, so to artificially obstruct arbitrageurs and free trading in one and not the other introduces undue distortions that lead to sub-optimal investment decisions.

To be fair, the selling of something not originally owned has always raised ethical issues, while the sight of crashing prices stirs many negative emotions, often leading to fingers being pointed at short-sellers and a clamour for some sort of official intervention.

Faced with tremendous public pressure to stem the bleeding, it is perhaps understandable - and possibly forgivable - for regulators to cave in and impose poorly thought out measures as was the case a fortnight ago.

Furthermore, US officialdom often finds itself burdened with the expectations not just of its own market, but also the world. For this reason it has a whole host of circuit-breakers in place which are not found in most other markets, measures aimed at preventing a full-scale crash that if left unchecked could wreak havoc around the globe.

However, as many have pointed out, short-sellers did not cause the sub-prime meltdown, nor were they in any way responsible for the inflation of the massive US housing bubble between 2001-2007 and the simultaneous enormous expansion of credit that lay behind it. (The real culprit may have been previous Federal Reserve chairman Alan Greenspan and the Bush administration, but we'll leave the blame game aside for now).

Furthermore, academic studies have shown that short-sellers do not earn abnormal profits by artificially driving prices down and instead provide liquidity and stability by buying into down markets.

So there is no real evidence that short-selling causes, aggravates or leads to stock market crashes; in fact, under rigorous scrutiny, all accusations levelled at the activity can be found to be mainly anecdotal.

Fortunately for local investors, officials here recognise that the less interference there is with the market mechanism, the better. Moreover, all the naked short-selling data provided by the Singapore Exchange (SGX) in the past week or so clearly shows that naked short-selling is not a major factor and SGX has sensibly adopted a disclosure-based approach to addressing short-selling concerns. If only other regulators were similarly predisposed, the selloff of the past fortnight might well have been less severe.