Published May 25, 2009

Short-selling fines: are criticisms unjustified?

By R SIVANITHY

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JUDGING by recent reports, the Singapore Exchange's fines for open short-sold positions (or 'naked' shorts) introduced last September are considered draconian, inflicting inordinate pain on ignorant - sometimes careless but mainly innocent - retail players.

For example, a punter who accidentally oversells a small amount of shares, perhaps a few hundred dollars' worth, and fails to cover the shortfall before trading closes at 5.05pm, has to pay a fine of at least $1,000 - a disproportionately big sum on top of possible further loss, when the position is forcibly covered or 'bought-in' four trading days later by the exchange.

It is claimed that this is unfair if the naked sale was due to an accidental keying-in error, or some other oversight on the seller's part. Also, with everyone seeing 'green shoots' sprouting on the economic front, punitive fines for genuine errors might deter retail punters who have only recently regained some confidence to re-enter the market.

So should SGX adopt a different tack and maybe lighten its supposedly heavy hand?

The first thing to note is that the size of the problem has been exaggerated by the affected parties. A look at the daily buying-in lists over the past week reveals that although the number of transactions to be bought in has risen compared to nine months ago (which is only to be expected given the surge in activity), the dollar value has actually fallen sharply, especially relative to overall business. On average, roughly $200,000-500,000 is now bought-in regularly - about one-tenth the value to be covered daily last September, when the measures were first implemented.

What's more, current buying-in values are no more than 0.01-0.03 per cent of the $1.5-2 billion business done daily in the whole market; in other words, over 99.9 per cent of daily transactions are now settled normally. So there is no undue strain on the settlement/delivery system - which suggests that the fines have achieved their intended objective. This is a point overlooked by most critics - the measures were not so much aimed at deterring short-selling as they were directed at preserving the integrity of settlements. For this reason, a much larger fine of $50,000 for short-selling in the buying-in market was quite appropriately also introduced last September.

Moreover (and many observers have also overlooked this), warrant issuers are happy that the measures have resulted in a near-complete end to naked short-selling in the structured warrants market - a crucial development if this segment is to recover to its former heights.

For years since warrants were introduced in 2002, issuers have lobbied for stricter rules to ban short-selling. The reasons for this have been explored in detail before in this column; in a nutshell, widespread short-selling of warrants prevents issuers from properly performing their market-making duties - and thus impedes development of the warrants market.

Although intraday shorting cannot be avoided, the current deterrents at least provide a neat solution to the problem of naked shorts. And provided confidence continues to return to the underlying market and structured products, issuers should now find their job much easier.

It might appear harsh to say this, but it has to be pointed out: all budding 'botanists', large or small, who venture into the stock market at any time must abide by the rules of the game and, for now, those rules state there are penalties if you oversell and don't cover the positions before the market closes each day. Those rules have had their desired effect - and the system appears to be working well.

Moreover, it isn't as if the Exchange is wholly unsympathetic or inflexible; it has said it will listen to appeals, and anecdotal evidence is that, if a genuine mistake can be proven, the appeals process has resulted in fines being waived.

Admittedly, this isn't perfect, and the authorities are studying alternatives. For example, the Society of Remisiers last December proposed the creation of an 'immediate delivery' segment similar to the cash market that existed in the 1990s, where shares can be bought and delivered immediately after an error is detected. This would then eliminate the need for fines or buying-in.

Another option probably being studied are the systems in Hong Kong and Australia, where brokers' trading systems are linked real-time to individual share accounts so that mistakes like overselling are not possible.

However, until a better alternative is found to SGX's existing system, the best that can be said is that everyone should learn to live with it and adapt to its constraints. In fact, the numbers show that the vast majority already have.