In Defence of Speculation

Quite what the burghers and burglar alarm manufacturers of Manchester gathered at a Commonwealth Games business breakfast made of the speech yesterday by Howard Davies, the chairman of the UK Financial Services Authority (FSA), is hard to say. He told

By None

Quite what the burghers and burglar alarm manufacturers of Manchester gathered at a Commonwealth Games business breakfast made of the speech yesterday by Howard Davies, the chairman of the UK Financial Services Authority (FSA), is hard to say. He told them that short selling is a useful source of market liquidity. Captains of industry tend not to see things that way. Far from appreciating the role of the short and medium term speculator in smoothing out price discrepancies and other fluctuations in the securities markets, they are more inclined to see almost everything which goes on in the City of London as a form of parasitism which feeds off the only real source of wealth: making things, such as burglar alarms.

Which is why those manufacturers who read the remarks by Legal & General CEO David Prosser which launched this latest attack on shorting – and those who aid and abet it in the securities lending industry – will have felt their hearts lift. It was Prosser who called on the FSA to investigate the activities of hedge funds, and perhaps even impose a tax on their activities, because their short-selling activities help to drive down stock market values. Prosser is both a predictable and an unpredictable source for such views. As a major indexed fund manager, L & G is both unable to sell but also neatly placed to lend its portfolios. In fact, the giant insurer says it has not lent since September 11 when, in common with a number of other insurance companies, L & G found its solvency ratio being imperilled by a sinking equity market. “The financial markets are highly efficient to ensure people can invest for the long term,” says Prosser. “The regime was not designed for institutionalised short selling.” He added that he would like to see “more grit in the system,” in the shape of some kind of turnover tax.

Similarly, David Varney, the chairman of MMO2 – as a telecommunications company, an enterprise which is invested, like insurance companies, in a market awash with negative sentiment – wrote recently in the Financial Times that “short selling [is] … a contributory factor in the recent falls in world stock markets.” He called for greater disclosure, on the grounds that trading in shares in his company was voluminous but the names on the shareholder register never changed, making it hard for him to monitor what was going on by allowing even large scale speculators to bypass the 3 per cent shareholder disclosure threshold set for large long positions in UK companies. “Investors have a right to know who has been going short of shares in companies they own,” he wrote. “And also, I would argue, to be told on a daily basis what the level of short interest in their stock currently is and not simply the aggregate figure for the London market.” He was clearly also irritated that the institutional holders off his stock were probably lending it to short sellers.

Such sentiments, understandable in the case of CEOs and chairmen whose performance is judged directly by the company share prices, are bound to be made in a bear market. But they cannot be ignored, because this hostility to shorting is not confined to the UK. In the wake of September 11, there was criticism in the US that shorting of airline stocks was in some sense immoral. German finance minister Hans Eichel has proposed a law banning short-selling in volatile markets altogether. The Japanese authorities came close to banning securities lending – which only recently came onshore there anyway – and have insisted not only that Japanese traders follow US practice and take short positions only after a price has moved upwards but that the Tokyo Stock Exchange publish data regularly about their activities. The ghost of Mahathir Mohamad, imposer of foreign exchange controls and sworn enemy of speculators everywhere, stalks Wall Street and the City.

Davies seem attracted by the idea of greater disclosure, telling his Mancunian audience that there is a case for greater transparency in short positions and that he will bring forward proposals in the autumn. It will scarcely be revolutionary, since regulators in the United States, Japan, Hong Kong and elsewhere all insist on some level of disclosure. Since obtaining information on short positions themselves is tricky without taking draconian powers, Davies favours looking at securities lending as a proxy for shorts. “One of the options we are examining is what can be done to make available to the market up-to-date information on volumes of short selling – or at least of stock lending as a proxy for this,” he said. “It is important to identify what would be of value to the market, how it could be supplied cost-effectively and how to avoid intruding into commercial confidentiality. But, subject to those caveats, we are sympathetic to arguments for greater disclosure. Markets rarely suffer from regulation that improves the flow of information. Any changes would have to be subject to a consultation process; and a decision to change would also have to allow adequate time for firms to make any necessary IT amendments to their reporting systems. But we will bring forward proposals in early October.”

This is worrisome. For a start, securities lending is not synonymous with shorting: it supports many different activities in the securities markets. Nor does stock lending soar in weak markets, as Davies explained. “The data we have from CREST show that levels of stock lending recently, when the markets have been falling fast, have not increased significantly compared to earlier in the year when the FTSE was trading fairly stably in the 5,000 to 5,300 range,” he says. “Stock lending has continued to represent around two per cent of total FTSE 100 stock. Nor do our contacts with the major equity market traders indicate any upsurge in the volume of short selling over the last few weeks. Even if there had been, it is not clear that one could link this causally to the decline in share prices. One recent published analysis could find no statistical link between changes in stock loan levels and share prices for FTSE 100 stocks. (I should in fairness note that the same study did find a link between large changes in lending for mid-sized firms and their prices. But mid-sized firms have not fallen any faster than FTSE 100 stocks during 2002). Some argue that there may have been an increase in intra-day short selling, which may not be picked up in these figures. But it is hard to see how intra-day trading could have a significant impact on prices over a period. And some of the sharpest price falls have occurred at the end of trading, at a time when intra-day short sellers would be closing their positions. “

It is often forgotten that stocks get shorted for real reasons – short sellers expect the price to fall, usually because the company is failing to perform – and that short sales are not always profitable. Markets obviously cannot function if they do not have sellers as well as buyers, and what results from their interaction is a set of relatively straightforward signals about what is going on in the real economy.

Markets are signalling systems and discovery mechanisms – of imperfect design and implementation, to be sure, but our only useful guide to what might happen next. It is not immediately obvious, for example, that the long-term holders of Enron and WorldCom did widows and orphans any favours. Nor are the “hedge funds” which tend as major borrowers of stock to be blamed for volatility – rather in the manner of the Gnomes of Zurich in the days of fixed exchange rates – a monolith. They pursue a wide variety of investment strategies. In fact, far from being sellers in a falling market, hedge funds are often the only buyers. It is institutional investors, fearful of breaching solvency ratios set by regulators, who tend to drive markets down by selling. And if institutional investors are worried that falling markets are threatening solvency ratios, they should complain to the regulators, not the markets.

But what is most worrying about the FSA enthusiasm for greater transparency is that any investigation into short selling – or, more exactly, securities lending as a proxy for it – will only encourage the idea that securities markets are akin to gambling dens. Howard Davies is aware of this, and was admirably robust in his speech in rejecting the idea of a ban on short-selling. As he pointed out, the FTSE-100 has done no worse than the CAC-40 or the DAX, both of which enjoy the protection of constraints on short selling. “I should make it clear, therefore, that we see no case for any outright ban on short selling, a practice which we judge a necessary and desirable underpinning to the liquidity of the London market,” he said. “No major market has taken such a step.” He was equally dismissive of the idea of imposing on London a US-Japanese style “uptick” rule or (worst of all) that old staple of the critics of casino capitalism: a Tobin Tax on the gains from speculative trading. But putting forward greater transparency as a harmless alternative to these undoubtedly damaging ideas does suggest the FSA thinks they have a point – either that, or the FSA must itself find further information about the practice of securities lending useful for other purposes. The FSA is already planning a ’roundtable’ of market practitioners and trade associations – including critics of short selling, as well as hedge funds and prime brokers – to share views on the practice in September. Expect it to end with a call to custodians banks, prime brokers, proprietary trading desks and others to disclose more about their activities.