FEATURE

The Debate on Short Selling and Securities Lending

Debate about short selling has raged for almost as long as financial institutions have existed with commentators blaming short sellers for many of the stock market declines and crashes of the past 400 years.

Particularly at times when equity prices are falling, commentators sometimes criticize securities lending on the grounds that it facilitates short selling of securities, which - it is claimed - can exacerbate price falls. They question why beneficial owners lend securities or call for tighter regulation of securities lending and/or short selling. Critics of short selling typically claim it is responsible for increasing share price volatility, intensifying price drops in declining markets and driving the price of individual stocks down, creating problems of damaged commercial confidence and difficulty in fundraising for the companies involved.

Andrew Shinn, Director of Business Development at SunGard's Astec business, offers his point of view on short selling and securities lending in the following interview.

Because securities lending is a necessary component for short selling, how do your institutional investor customers feel about the recent spotlight on short selling?

Some of the beneficial owners of our agency lending customers have had concerns about the potential negative effects of short selling. However, once we go over the research that demonstrates the benefits of short selling, as well as securities lending to capital markets and the economy as a whole, they realize that they have made a good decision to lend their stock.

While short selling is sometimes blamed when the market falls, short selling and securities lending increase market efficiency and liquidity, and lower the volatility of the cash markets. In a study conducted a few years ago, we found that short sellers have provided a price cushion during recent market downturns. Specifically, the short sellers closed their outstanding short positions by purchasing shares on the open market when few other investors were willing to buy. To bring the issue home for all types of investors, short selling reduces the risk that the price of a purchased share of stock is artificially high. Short selling essentially makes markets more efficient by incorporating all buy and sell interest.

There is a common misconception that short sellers have a fundamentally negative view of the stock being shorted. This is not necessarily the case as there are other reasons why a stock may be sold short. For example, there are arbitrage strategies that seek to exploit mispricing between different stocks. In these cases, the short sale is coupled with a long position, so the net impact on the market as a whole is neutral.

This isn't the first time that short selling has found itself in the spotlight. How has short selling and the regulation of it evolved?

The first known instance of short selling regulation was enacted in the Netherlands in 1610 when the Dutch government banned the practice of "trading the wind" or trading in shares that an investor did not own.

In 1733, a little over three decades after the founding of the London Stock Exchange, the British Parliament also banned short selling. However, the markets and the courts largely ignored the ban and the government repealed it in 1860 only to reinstate it seven years later to protect banking stocks after the collapse of a large bank. As a government commission determined, however, poor management caused the bank failure, not short sales.

Napoleon even tried to ban short selling because he felt short sellers were frustrating his schemes to use the French financial system for his personal gain. Nevertheless, in 1885, a new law was introduced in France specifically legalizing short selling.

Short selling regulation in the U.S. began after the 1929 crash and remained essentially unchanged for the next 70 years until the SEC implemented new rules called Reg SHO in 2004.

How do regulators address the issue of naked short selling?

Naked short selling is a concern because it increases the number of sell orders, inflates short interest and could drive down share prices. Abusive naked short selling is combated specifically in the U.S. with Reg SHO, a fundamental short selling regulation. Reg SHO instituted stringent new "locate" and "close-out" requirements for stocks that are routinely experiencing large failures to deliver. For those securities that are not being delivered on time, every SEC-regulated broker must certifiably locate shares to borrow before engaging in a short sale. As short sellers are required to borrow, lenders will be the ultimate beneficiary as lending volume increases.

How does regulation address the issue of borrowing
shares to vote proxy?

The possibility of manipulating proxy voting is a serious concern because it would undermine the corporate governance process. The important thing to understand, however, is that while there are ways for manipulation to occur through derivative contracts, there are safeguards in place in the securities finance industry to protect the integrity of the markets. For example, Reg T in the U.S. prohibits broker-dealers from borrowing shares, except for permitted purposes that include executing short sales, covering fails-to-deliver or market making. The Securities Borrowing and Lending Code of Guidance in the U.K. also states that stock should not be borrowed for the sole purpose of voting.

While it is technically possible to unbundle voting and economic exposure via a swap or put option, it is quite costly and sometimes impossible to execute. In order to unbundle, a fund must pay a derivatives dealer to write a contract. The price of that contract will depend on the cost to borrow shares in the lending market because the derivatives dealer will need to hedge its newly-created exposure. Therefore, the cost-to-borrow is a naturally constraining force.

Andrew Shinn is the Director of Business Development at SunGard Astec Analytics. Astec specializes in providing market information for the global securities finance industry.

Andrew helped research and co-wrote Impact of Short Sales and Securities Lending on Capital Markets: 1990 - 2006, a study demonstrating that short selling and securities finance provide important benefits to all market participants, such as reduced volatility and increased liquidity. Andrew also helped establish the Center for the Study of Financial Market Evolution, a non-profit research center whose goal is to improve the public's understanding of mechanisms that support the efficiency of financial markets in various stages of their evolution.

Andrew speaks to pension fund boards of directors regarding their securities lending programs and has been a panelist at several securities lending and alternative investment conferences. Andrew graduated from Fordham University with a degree in economics and is a Level 3 CFA candidate.