Regulation for regulation's sake?

The European Commission’s paper, Short Selling, underwent a consultation period which ended in late July. The intention was to receive feedback from market participants on their views of how a pan European approach to short selling regulation and disclosure should be considered. It also allows the market to highlight concerns and risks of introducing such regulation and disclosure.

There is wide scale recognition among regulators that short selling plays an important role in financial markets and this sentiment is reiterated in the introduction to the consultation paper. However, there are also comments in the introduction that short selling can be used in an abusive fashion, that it can contribute to disorderly markets and amplify price falls in extreme conditions and can have an adverse effect on financial stability.

Bold statements indeed but the evidence for this is somewhat scant. To describe short selling as having the ability to be used in an abusive manner must refer to “naked” or uncovered short selling as the culprit given the regulatory endorsement covered short selling has already received. A naked short sale is one where the seller makes no attempt to borrow the security and is therefore unconcerned with the failure to deliver their actions cause. 

It is the settlement process where we might turn to establish the size and frequency of fails to put this into perspective. Crest data for June 2010 as supplied by Euroclear reports a 95.5% settlement rate on contractual date on FTSE 350 stocks with a daily average of 122,901 deliveries. This performance is consistent with prior months. For the sake of argument, let’s assume every one of the 5,530 average daily failed transactions is as a result of a naked short sale.

One year rise

The FTSE 350 over the last 12 months rose about 38% between July 2009 and May 2010 and yet failure to deliver percentages remain in line with those described above. Obviously statistics surrounding individual stocks and the duration of failed transactions would be of interest and an exercise worth pursuing. In general terms however it appears unlikely that short selling, naked or covered has no negative impact on markets. Failed statistics remain constant around the 5% mark throughout this period and did not increase during the market decline between late April and July of this year. 

Turning to Data Explorers content, in the last year, we have seen no marked increase in lendable supply or changes in utilisation (the amount of lendable supply actually out on loan) across the FTSE 250. Our data is also used as a good proxy for covered short selling and even during the recent market decline, utilisation has actually slightly dropped.

There is a danger that regulation may be introduced unnecessarily to curb an activity that has no material impact on prices or market stability. Naked short selling is a poor practice and perhaps the best way to address this is via a form of settlement penalty. This approach however has its consequences too, as it may motivate lenders to hold greater reserves of stocks that their fund clients have tasked them to lend for incremental revenue purposes. The debate will no doubt continue and it is important that the consequences of any regulatory introduction is understood by all.

John Arnesen is senior business consultant at Data Explorers; www.dataexplorers.com