the gulf | December 13-19, 2008

opinion

33

by Robert Aspin

Whatever one thinks of the way that Porsche was able

in October to gain effective control over 74 per cent of volkswagen’s stock – causing a short squeeze of 400 per cent in the process – short sellers have come under undue pres-sure of late. Shorting, or selling short, is when an investor agrees to sell securities that he or she does not already own. the investor is betting that the price of the securities will fall by the time they must be delivered. If they do, the seller makes a profit on the deal. If they do not, the seller must buy them at a premium and so could lose money.

In most cases, short selling is used by investors as a way to hedge positions that are held long – that is, in the belief that they will rise in value. For example, an investor holding toyota shares may wish to hedge some of the market or sector risk by shorting a similar value of shares in General Motors, a company whose fundamentals are less sound. too often, however, short sellers are blamed for causing stock markets to fall as was the case recently. Because of such perceptions, regulators in the US not so long ago banned any new short selling in the shares of some 900 firms in an effort to support the equity markets. the UK and european regula-tors did likewise on a number of financial stocks. all this did was contribute to a huge short squeeze – when a shortage of supply and excessive demand push up the price of a stock – and did nothing for the longer

term stability of the markets which continued to fall several days later. the regulators later dropped the ban because they realised it was ineffective.

In banning mechanisms such as shorting, the regulators end up either manipulating the markets themselves or facilitat-ing the attempts of others to do so. as a result, they fail in their duty to provide a level playing field for participants in the equity markets. Such failures not only affect short sellers directly but lead to distrust in the system. For example, investors who were legitimately shorting Citibank or hBOS shares may have been forced, on the back of the resul-tant short squeeze, to cover their positions or to sell other stocks in order to meet calls for margin from brokers or others from whom they had borrowed money. as this can cause inves-tors to sell holdings in other stocks, the impact cascades through the markets and leads to dislocations in prices.

In many cases such misguided tactics on the part of regula-tors lead to losses which have resulted in the closure of some hedge funds. this benefits few market participants and again creates price dislocations as positions are closed.

Short sellers also provide improved market pricing since expensive stocks can be sold down in price, while cheap stocks are bid up. a further benefit of shorting – and a criti-cal one too – is that it provides liquidity if a market reaches a point of panic and becomes over-sold. Short sellers are the first buyers in any market as they seek to cover their posi-tions and to reduce any hedges

that they may hold. hedge funds, short sellers and merger arbitrage managers all add to the liquidity of the markets which contributes to their abil-ity to operate effectively.

While shorting is a means of reducing portfolio risk – hedg-ing a position in a stock, using shorts, helps to reduce a fund’s volatility and the impact of a fall in the market – short sellers assume significantly more risk than most investors since the loss on a short can far exceed the loss on a long trade. By definition, this is limited to 100 per cent of the value of the investment. It is thus critical that they can operate in a fair, liquid and transparent market. rather than castigating them, regulators and market partici-pants should applaud short sellers for what they bring to financial markets.

they accept the risks of their profession but should not have to endure manipulation by those who would prevent it. this jeopardises the very foundation of an equity market, which is what regulators are trying to defend. China’s recent decision to allow shorting on its

markets should be a wake-up call to regulators elsewhere.

the story of volkswagen had a happy end to it, at least for Porsche. the firm later announced that it would provide some liquidity to the market by exercising part of the cash option on the vW shares it had acquired. Given that Porsche profited signifi-cantly from the decision, the company’s own stock rose by more than 30 per cent on the announcement. Speculation continues as to whether the company will exercise the remaining options for cash or acquire the underlying stock. Was it manipulation on an unprecedented scale? I know what I think. <

Robert Aspin has more than

14 years of international experience in the financial

sector. He has submitted an application to the Central Bank of Bahrain to establish an asset

management firm

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Tim

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financial markets

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