report on short selling

7/31/2019 Report on Short Selling

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BRIEFINGS

ONMARKETPRACTICE

SHORT SELLING

March 2009


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March 2009

Dr. Bandi Ram Prasad

President([email protected])

Dr. Jinesh PanchaliSenior Vice President([email protected])

Financial MarketsAbhinav ChopraShrikant KoundinyaDr. Raosaheb MohiteHitesh SethiaBhairavee MahadikGiridhari KawadkarSuprabhat KumarVinit Singh KalerSunit Math

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This update has contributions romDr. Bandi Ram PrasadWith imputs rom

Dr. Jinesh Panchali

Financial Technologies Knowledge Management Company LimitedWebsite: www.ftkmc.com Email: [email protected]

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One o the aspects o securities markets operations that came intointense scrutiny and stringent regulatory actions is the practice oshort selling or short interest. The collapse o the structured productsmarket has severely aected the nancial health o a large numbero global nancial institutions owing to large-scale provisioning and

write-downs. This led to massive sell-o o the shares o the aectedbanks and nancial institutions.

Fears o massive short selling accentuating the sell-o that couldhave led to the dramatic decline o shares o nancial companieshave prompted regulatory agencies all over the world to look atcertain aspects o short selling and come out with some pre-emptivemeasures.

Once again, the subject o short selling has become a topic odebate and discussion. This report presents important aspects oshort selling, including recent developments and the evidence romregulatory actions.

What Is Short Selling?Short selling is the practice o selling shares that the seller does notown at the time o trading. In short selling, the security is usuallyborrowed rom a brokers account and sold in anticipation o adownturn, where it may be repurchased at a prot. The adage Buylow, sell high applies to a short-seller. It is only the order o the tradethat is reversed in the case o short selling the stock is sold rst ata higher price and bought later at a lower price.

A typical short-sell transaction would have three parties (the originalowner or the lender, the short-seller, and the new buyer), unlike anormal share purchase transaction, which consists o two parties(the buyer and the seller).

A short-seller is required to open a margin account with a broker andsign an agreement saying that he (the short-seller) will maintain acash margin or pledge his stocks as collateral. The margin accountallows him to borrow rom the broker, based on the value o hisportolio (which is usually at least 50% o the size o the short-selltransaction).

introductionINTRODUCTION


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March 2009

Types of Short SellingShort-sell transactions are o two types, naked and covered.

In naked short selling, the seller sells shares he does not own, without having set aside any shares to settle thetransaction. There are no borrowing ees in this transaction since he did not borrow the shares that have beensold; however, it would normally be subject to any ees that the broker requires to hold the position open. Whenit is time to exit the short position, the short-seller relies on the same number o shares being available, so that

he can buy them back closing the short position. Naked short selling is oten used or intra-day trading, wherethe position is opened and then closed at some point later in the day. Also, i a market maker does not have asucient supply o a particular share to meet client demand then the market maker may employ naked shortselling in order to meet that demand.

Covered short selling usually involves a series o transactions.

In the rst stage, the short-seller normally borrows the number o shares that are or short selling so thatthey can be delivered to the buyer at settlement. The short-seller will normally get cash on delivery o thestocks.

In the second stage, he short-sells the shares.

In the third stage, which occurs at some point in the uture, he buys the same number o shares so as toreturn them to the original lender.

In the ourth stage, the replacement shares are returned to the original lender and the series o transactionsis complete.

In addition to the cash markets, short selling can also be carried out by using a number o dierent derivativeinstruments, although some o these methods can be hedged by selling in the cash market. For example, ashort position can be taken through single stock utures, index utures, options, etc.

Short Seller

lending fee

current

market price

Shareborrowing

Share selling

Market

Lender

Step I and II:

Shares are sold short after

borrowing from lender

Short Seller

currentmarket price

Market

Step III and IV :

Repurchasing and

Share Return

Lender

Share return

Sharepurchasing


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An eective acility or securities lending and borrowing can be animportant instrument in the orderly conduct o short selling.

Why Use Short Selling?Short selling is used to achieve various objectives in todays markets.The IOSCO documents on short selling list the ollowing uses:

Establish a short position in a security considered to be over-valued, believing that it will be possible to buy it back morecheaply in the uture.

Enable dealers/market makers who do not currently hold therelevant securities in their inventory to ll customer buy orderson demand.

Facilitate long/short investment strategies, in which portoliosare split between long and short positions with a view toproting rom a relatively stronger perormance o the longholdings vis--vis the short holdings.

Lock in an arbitrage prot when an arbitrager exploits a pricinganomaly between two related instruments by buying the cheapone and short selling the dear one.

Facilitate hedging, especially o derivative contracts, by enablinganyone exposed to a commitment to buy securities to oset theirmarket risk by establishing a corresponding short position.

Balance a long position, generally or a specic purpose; e.g.,protect a long interest being held or strategic reasons orbecause it might be scally disadvantageous to crystallize a

prot through a long position.

Facilitate the movement o new securities into the market underapproved procedures such as price stabilization or greenshoerules; e.g., when stock is sold by an issue manager or othermembers o a distribution syndicate to meet strong demand orsecurities in the knowledge that the issuer will make availableadditional securities to cover their shorts.

Stock Lending

In a practical sense, the term stock lending is used

to describe the temporary transer o securities by

one party (the lender) to another (the borrower).

The securities on loan are secured either by cash

collateral or securities/asset collateral. Under the

loan agreement, title to the securities passes on

to the borrower. This is more akin to a sale and re-

delivery than borrowing as such. Where lenders

have agreed to take securities as collateral, they are

paid a ee. I lenders take cash as collateral, they pay

the borrower interest at a lower than market rate,

known as the rebate rate. This allows the lender to

reinvest the cash and make a return. However, the

borrower is obliged to return the securities to the

lender either on demand or at the end o an agreed

term. A common reason to borrow securities is to

cover a short position. However, this position may

not necessarily be a result o speculative activity; itmay arise rom a dealers need to borrow securities

to provide them or customers making buy orders

or as a result o ailed settlement. Market makers

borrow stock to ll client orders and ensure tight,

two-way prices. Securities lending allows market

makers to increase liquidity, which in turn helps

the markets operate more smoothly and eciently.

Borrowing o securities also occurs as part o

nancing strategies.


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March 2009

Who Are Short-Sellers?The main short-sellers dier considerably rom market to market. Dierences are likely to refect such actorsas market microstructure (e.g., the role o market makers), liquidity (since low liquidity will tend to deter undmanagers and other investors rom using short selling strategically), and the nature o any restrictions on shortselling activity imposed by regulators or market authorities, or under investment laws or mandates.

Market makers/principal dealers

In equity markets, where market makers play a predominant role or intermediaries commonly acilitatecustomer trades on a principal basis, the major intermediaries are requently a major source (i not the majorsource) o short selling activity. They may go short when lling customer buy orders on demand, as part otheir proprietary trading or as part o the general risk management o their inventory. Although many tradingpositions are covered, or largely covered, by purchases made over the rest o the trading day, liquidity providersare generally active stock borrowers too.

Hedge undsA second major group that uses short selling is hedge unds. Hedge unds are ar more active on both sideso the market (i.e., the long and the short side) than long-term institutional investors, such as pension unds.When pursuing momentum strategies, they take substantial short positions as well as long positions (thoughthe number o short-only unds is a very small proportion o total hedge und assets). When adopting a moremarket neutral approach, they utilize various long/short strategies, designed essentially to secure returns inany market conditions by correctly predicting trends in relative prices.

OthersMostly, major long-term und managers (e.g., o pension and insurance unds) do not use short selling. Inaddition to being natural long-term holders o the securities they acquire, they are also oten prohibited rommaking short sales, either by regulation or under the contractual or other terms governing investment policyin respect o the unds that they manage. The extent to which private investors use short selling depends bothon local investment practice and culture, as well as local regulation. In some markets, there is retail demandor short selling acilities and the markets have developed services to acilitate this, in particular, through theprovision by brokers or specialist houses o retail stock lending acilities. These are commonly used in, orinstance, Japan, the US, and Canada. In other markets, there is less interest on the part o private investors, andbrokers are disinclined to invest in the operational inrastructure they would need to support such a service.

History of Short SellingThe rst case o short selling dates back to 1609 when Dutch trader Isaac Le Maire, a big share holder o theVereenigde Oostindische Compagnie (VOC)the Dutch East-India Company, was blamed or causing a dropin the share price o the company. Way back in 1602, Le Maire had invested about 85,000 guilders 1 in theVOC. By 1609, the VOC still was not paying dividends, and Le Maires ships on the Baltic routes were underconstant threats o attack by English ships due to trading conficts between the British and the VOC. Le Mairedecided to sell his shares and sold even more than he had. Under pressure rom the directors o the VOC, theDutch government regarded this as an outrageous act and took steps to eliminate selling o shares or orward

delivery that were not owned by the seller at the time o the orward sale. In modern sources, e.g., de Marchiand Harrison (1994), this has been portrayed as a ban on short selling. The ban was revoked a couple o yearslater.

Short selling has been a target o ire since at least the eighteenth century when England banned it outright. Itwas perceived as a magniying eect in the violent downturn in the Dutch tulip market in the 17th century. Inanother well-reerenced example, George Soros became notorious or breaking the Bank o England on BlackWednesday o 1992, when he went short more than $10 billion worth o pounds sterling.The term short was inuse rom at least the mid-19th century. It is commonly understood that short is used because the short-selleris in a decit position with his brokerage house.

Short-sellers were blamed or the Wall Street Crash o 1929. Regulations governing short selling were

implemented in the US in 1929 and in 1940. Political allout rom the 1929 crash led Congress to enact a lawbanning short-sellers rom selling shares during a downtick; this was known as the uptick rule, and was ineect until 2007. President Herbert Hoover condemned short-sellers and even J. Edgar Hoover said he wouldinvestigate short-sellers or their role in prolonging the Depression. Legislation introduced in 1940 bannedmutual unds rom short selling (this law was lited in 1997). A ew years later, in 1949, Alred Winslow Jones


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ounded a und (that was unregulated) that bought stocks whileshort selling other stocks, hence hedging some o the market risk,and the hedge und was born.

Some typical examples o mass short-selling activity are duringbubbles, such as the dot-com bubble. At such periods, short-sellerssell hoping or a market correction. Negative news, such as litigationagainst a company, will also entice proessional traders to short-sellthe stock.

In September 2008, short selling was seen as a contributing actorto undesirable market volatility and subsequently was temporarilyprohibited by the US Securities and Exchange Commission (SEC) or799 nancial companies in an eort to stabilize the market price othe company stocks. This was ollowed by similar prohibitions rommarket regulators in the UK, Australia, and Spain, to name a ew.

The uptick rule also known as the plus tick rule

is a securities trading rule used to regulate short

selling in nancial markets. The rule mandates that

every short-sell transaction be entered at a price

that is higher than the price o the previous trade.

This rule was introduced in the Securities Exchange

Act o 1934 as Rule 10a-1. The uptick rule prevents

short-sellers rom adding to the downward

momentum when the price o an asset is already

experiencing sharp declines. The SEC made the

controversial decision to eliminate the uptick rule

in June 2007 ater its analysis showed it did little to

prevent the manipulation o share prices. However,

Federal Reserve chairman Ben Bernanke said i the

rules were still in place, it might have had some

benet in preventing the market meltdown.

1The guilder Dutch gulden was the currency o the Netherlands rom the 13th century until 2002, when it was replaced by

the euro.

Studies on Short SellingThe study on short selling has been sizeable. Because short selling is considered as an important actorleading to better price discovery, greater liquidity, and market eciency, the topic was o signicant interestto researchers and nancial proessionals rom the perspective o regulation and market practice. The studiesare conducted on a number o aspects relating to the operation o short selling. A recent study on short sellingby Financial Services Authority, UK, notes that a general view o the empirical literature is that short sellingallows negative expectations about share price developments to eed more directly into the actual share price,thus leading to ecient price discovery process. There were also studies ollowing the temporary restrictions

imposed on short selling in several countries ollowing the regulatory actions in the US in September 2008.

A gist o the major studies conducted on short selling and their respective ndings are given below.

Seneca (1967) An increase in short interest was a bearish indicator.

Miller (1977) Inormed, bullish investors may orce stock prices above the price that would prevailin the absence o short-sell restrictions, leading to overpricing securities. Wheninormed, bearish investors are willing and able to sell short, negative inormation ismore rapidly incorporated into stock prices, resulting in ew overvalued securities. Inthe absence o short selling, stock prices tend to refect the view o the more optimisticinvestors.

Harrison and Kreps(1978)

Short-sell constraints can result in stock prices that exceed the valuation o even themost optimistic investor.

Diamond andVerrecchia (1987)

Although short-sell restrictions do not lead to an upward bias in prices, they do reducethe speed at which stock prices adjust to privateespecially private negativeinormation. Short-sell restrictions will reduce liquidity during downward pricemovements.

Asquith, et al. (1995) Strong negative relation between short positions and returns, both during the timethe stocks are heavily shorted and over the ollowing two years. Short positionsconvey negative inormation about a stock, which eeds into its valuation.

Saeddine, et al.(1996)

Seasoned equity oers are preceded by abnormally high levels o short selling. Higherlevels o short selling are associated with reduced proceeds rom the equity issue.

Aitken, et al. (1998) Short selling is likely to be involved in arbitrage, or activates hedging, and tradesexecuted near the end o the year are less likely to precipitate a negative pricereaction. Restrictions on short selling discourage liquiditymotivated traders leavinga preponderance o inormationally motivated behaviour.


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March 2009

Houge, et al. (2001) Institutional controls restrict short selling in the early post-oering period.

Gintschel (2001) Stocks with unexpectedly low short interest experience signicantly positive abnormalreturns (21 basis points) upon announcement, while stocks with unexpectedly highshort interest have signicantly negative abnormal returns (23 basis points).

Chen, et al. (2002) Stocks that experience declines in breadth o ownership (used as a proxy or shortconstraints) subsequently underperorm those that experience increases.

Desai, et al. (2002) Heavily shorted rms exhibit signicant negative abnormal returns even atercontrolling or other actors. The negativity o returns is positively related to the level

o short positions. Heavily shorted rms are also more likely to delist rom NASDAQthan rms with otherwise similar characteristics.

Oek, et al. (2003) Substantial practical short-sell constraints or Internet stocks during the dotcom bubble.The burst o the bubble coincided with the expiration o lock-up agreements.

Christophe, et al.(2004)

Negative relationship between short selling prior to an announcement and the post-announcement change in share prices and that abnormally large changes in shortselling are oten ollowed by substantial post-announcement share price movements.Short-sellers appear to be more ocused on stocks with low book-to-market valuationsor low standardized unexpected earnings. More extensive and timely disclosures oshort-selling activity could increase the amount o inormation available to investorsand thereby improve market eciency and the orderliness o movements in securitiesprices.

Lamont (2004) Firms underperorm in the year subsequent to legal and regulatory action, a resultconsistent with the hypothesis that short-selling constraints acilitate stock overpricingand low subsequent returns.

Charoenrook andDaouk (2005)

Less volatile aggregate stock returns and greater liquidity in markets permit shortselling. Prices tend to increase when short-sell restrictions are lited. Removingrestrictions on short selling leads to gains in eciency.

Bai, et al. (2006) Stock prices may actually be lower with short-sell restrictions because investorsdemand a higher risk premium.

Boehme et al. (2006) Short selling, which helps impound negative inormation into prices, acts as acounterbalance to incentives to infate share prices.

Bris, et al. (2007) Short selling does not aect the requency o extreme negative returns. However,without short-sell restrictions, extreme returns become more negative.

Alexander andPeterson (2008)

No evidence that the temporary suspension o price tests negatively impacted marketquality as measured by liquidity, volatility, and price eciency.

Boulton, Braga Alves(2008)

Short-sell restrictions negatively impacted the market quality o the stocks they weredesigned to protect. Restrictions on short selling have a negative impact on marketquality and the price discovery process.

Sources: IOSCO, FSA, Boulton and Braga-Alves (2008)


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Concerns on Short Selling

Short selling has always been under the regulatory scanner, the latest being a series o restrictions imposedby the US Securities and Exchange Commission (SEC) in July 2008 in response to the steep decline in shareprices o nancial stocks, ollowing a similar decision by the UKs Financial Services Authority (FSA). The premiseo the regulators was that short-sellers were engaging in market manipulation, especially o nancial sectorshares, without basing their decision on market undamentals. Healthy banks were suering as a result, andthe concern was expressed.

This concern is a refection o the decline in stock prices o major banking and nancial institutions over theyear, and especially in the later hal, as seen in the price charts below. The seriousness o events prompted USauthorities and market regulators in several major economies to impose restrictions on short selling in an eortto reduce volatility and stabilize markets.

JP Morgan Citigroup

Bank o America Goldman Sachs

Credit Suisse UBS

Deutsche Bank HSBC


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Boeing Co Caterpillar Inc

American Express Co International Business Machines Corp(IBM)

NYSE Financial Index American International Group (AIG)

2000

3000

4000

5000

6000

7000

8000

9000

1/2/2008 4/2/2008 7/2/2008 10/2/2008 1/2/2009

NYSE Financial Index

Beyond the banking and nancial stocks, the stocks that led in pulling the stock market toward 11-year lowswere leading industrial companies and manuacturers o basic consumer goods. The decline in the Dow JonesIndustrial Average rom a record high in October 2007 to the low in November 2008 was contributed byAmerican International Group (539.17 points), Boeing (519.62 points), Caterpillar (398.29 points), IBM (370.59points), and American Express (364.42 points).

Regulatory Action on Short Selling:

A Global Overview

In 2008, a wave o restrictions on short selling was announced by major markets. On July 15, 2008, the SecuritiesExchange Commission o the United States issued an emergency order with an objective to enhance investorprotection against naked short selling in the securities o Fannie Mae, Freddie Mac, and primary dealers atcommercials and investment banks. The Order required that anyone with short-sell positions should arrangebeorehand to borrow the securities and deliver them at settlement. The Order, which was originally to beterminated on July 29, was later extended upto August 15, 2008. The stocks o the ollowing institutions werecovered under the Order.

1. BNP Paribas Securities Corp2. Bank o America Corp3. Barclays PLC4. Citigroup Inc.

5. Credit Suisse Group6. Daiwa Securities Group Inc.7. Deutsche Bank Group8. Allianz SE9. Goldman Sachs Group Inc.10. Royal Bank ADS

11. HSBC Holdings PLC ADS12. JP Morgan Chase & Co.13. Lehman Brothers Holdings Inc.14. Merrill Lynch & Co, Inc.

15. Mizuho Financial Group Inc.16. Morgan Stanley17. UBS AG18. Freddie Mac19. Fannie Mae


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Though these restrictions were or a limited period, in some countriesthese restrictions have lapsed, whereas in a ew others these areextended or put under review.

The restrictions on short selling have lapsed in the US and Canadaand expired in the UK, Austria, Italy, and the Netherlands in January2009. These will expire by March 2009 in Belgium, Germany, and

Japan, and by May 2009 in Greece. As o January 2009, short sellingrestrictions are still under review in a number o countries, includingDenmark, Hungary, Iceland, Ireland, Korea, Luxembourg, Norway,Portugal, Russia, Singapore, Spain, Switzerland, and Taiwan.

What type o shortposition is coveredby the prohibition?

What is the thresholdor any disclosureobligation?

Physical (P) oreconomic (E)interest caught?

Exemptionavailable or marketmaker or equivalent

United

Kingdom

Net Position 0.25% o issued share

capital

E Y

United States Naked and covered 0.25% o issued sharecapital

E Y

Australia Covered Any net short position P Y

Austria Net Position 0.25% o issued sharecapital

E N

Belgium Naked 0.25% o issued sharecapital

E Y

Canada Naked and covered N/A P Y

France Naked 0.25% o issued sharecapital

E Y

Germany Naked N/A P Y

Hungary N/A Any short position P N

Ireland Net Position 0.25% o issued sharecapital

E Y

Italy Naked N/A P Y

Korea Naked and covered N/A P Y

Luxembourg Net Position N/A E Y

Netherlands Naked 0.25% o issued sharecapital

P Y

Portugal Naked 0.25% o issued sharecapital

E Y

Russia Naked and covered N/A P N

Singapore Naked N/A E N

Spain N/A 0.25% o issued sharecapital

E N

Switzerland(SFBC/SWX)

Naked N/A P N

Switzerland(SWX Europe)

Net Position N/A P N

Taiwan Naked and covered N/A P N

Note: Physical interest indicates the actual sale o the security, whereas economic interest denotes any instrument (short positions underoptions and other derivative instruments reerencing the shares) giving rise to an exposure, whether direct or indirect, to the issued share

capital o a company.

Source: Cliord Chance LLP, September 2008

Following the US action, several countries in Europe and Asia have announced varying degrees o restrictions onshort selling. The UK imposed temporary restrictions on September 18, 2008, ollowing the market turbulencethat rose out o collapse o Lehman Brothers. During this period, more than 20 countries announced restrictionson short selling. (See table below.)


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Nature o Restrictions Imposed in Each Country

Country Financials Non-nancials

Ban Naked Cover Phys Econ Ban Naked Cover Phys Econ

Australia Y Y Y Y N Y Y Y Y N

Austria N N N N N N N N N N

Belgium Y Y N N Y N N N N N

Canada Y Y Y N Y N N N N N

France Y Y N N Y N N N N N

Germany Y Y N Y N N N N N N

Greece N N N N N N N N N N

Ireland Y Y Y N Y N N N N N

Italy Y Y N Y N N N N N N

Japan N N N N N N N N N N

Nether. Y Y N Y N N N N N N

Portugal Y Y N N Y N N N N N

Spain N N N N N N N N N N

Sweden N N N N N N N N N NSwitz. Y Y N Y N Y Y N Y N

UK Y Y Y N Y N N N N N

US Y Y Y N Y N N N N N

Note: The rst column in each section (Ban) denotes whether a new restriction was placed on short selling nancial and non-nancial

stocks respectively. The second and third columns denote whether this was a ban on naked and/or covered short selling. The ourth and

th columns denote whether the ban related to physical or economic positions.

Source: The Impact o Short Sale Restrictions, Marsh and Niemer, November 2008

ConsultationsSeveral consultations on short selling are undertaken. The Committee o European Securities Regulators(CESR) called or evidence rom market participants on short selling to help a task orce constituted or thepurpose. The task orce is mandated with three important aspects: (1) to assess the impact o the measuresthat were initiated by the CESR members; (2) consider the range o policy options or taking a more convergentapproach; and (3) enhance the coordination and cooperation between CESR members on the decisionstaken at the national level. In January 2009, Financial Services Authority o the United Kingdom published aDiscussion Paper on Short Selling, giving scope or consultations on this till May 8, 2009. The Discussion Paperexplored several ways o imposition o restrictions on short selling, which include prohibiting short sellingo all stocks; prohibiting naked short selling; prohibiting short selling o nancial sector stocks; prohibitingshort selling o stocks in companies engaging in rights issues; prohibiting short selling by underwriters orights issues; prohibiting short selling where there is urgent needs; introducing circuit breakers and a tick rule.Notwithstanding the above options, the paper concludes, We do not think any direct constraints on shortselling are currently justied. Nevertheless, extreme market conditions could re-emerge where the risks posedby short selling warrant some orm o emergency intervention, most likely in the orm o a prohibition. So,we will continue to monitor markets and stand ready to reintroduce a prohibition should this be warranted, inecessary without consultation.


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Questions or Consultation

The Discussion Paper by the FSA has raised the ollowing questions or consultation:

1. What are the views on the costs and benets o a blanket ban on short selling? (Please quantiy whereverpossible.)

2. Do you agree that there should not be a ban on all orms o short selling?3. Do you think any urther measures are necessary to deal with the naked short selling? I so, what is required

and why?

4. Should short selling o nancial stocks be banned permanently?5. Do you agree that, subject to having a satisactory disclosure regime, we should not ban short selling o the

stocks o companies engaging in rights issues?6. Do you agree that we should not ban short selling by underwriters o rights issues? (O the shares they are

underwriting or the duration o the underwriting process.)7. Should we intervene to ban short selling on an emergency basis wherever necessary? ( For example, to

combat market abuse and /or to maintain orderly markets.)8. Do you agree that no additional circuit-breakers should be introduced?9. Do you agree that we should not introduce a tick rule?10. Are there any other direct constraints on short selling that you think ought to be considered? (I so, please

provide inormation regarding their costs and benets.)

ResponsesThe Board o Directors o the World Federation o Exchanges, a global body o the stock exchanges, in a recentstatement said, Short-selling is a well established market mechanism, which contributes to their liquidity andeciency. It should be conducted subject to regulations which enhance the publics condence in exchanges.Rules governing short-selling should include borrowing and delivery requirements, and should be strictlyenorced. All short-selling transactions should comply with rules prohibiting market manipulation.

The responses o a sample o institutions in a consultation conducted by the Committee o European SecuritiesRegulators are reproduced in the ollowing table.

Institution Response to the CESR Call or Evidence on Short Selling

London StockExchange

While we recognize that regulatory intervention was taken in a number o countries dueto widespread concerns about market volatility, we believe that short selling is an integralpart o the proper unctioning o equity markets and a legitimate investment technique.Research commissioned by us on the eect o the recent ban on short selling introducedin the UK ound that market quality (dened as price volatility and liquidity) was reducedin the aected stocks in the period ollowing the ban. The research was UK-ocused, butwe believe the ndings will be o interest to all CESR members who have implementednational short-selling restrictions.

European BankingFederation

There are divergent views about the impact o the recent bans and restrictions imposedby some CESR members on short selling, and more work is necessary to establish whetherthese initiatives have reached their objective; whether some kind o restriction can, ingeneral, be a useul tool to calm down markets in exceptional circumstances, such asthose that occurred in the third quarter o 2007. However, there is agreement among

market participants that there should be no general ban o short selling or o securitieslending; as well as about the harmul consequences that arose rom the divergencesacross member states in the measures that were taken. I urther research demonstratesthe added value o such measures, we believe that reporting and/or disclosure solutionswould be the preerable solution. However, in this case, a number o urther questionsabout the substance and way o making the disclosures would need to be claried. Wecaution that any measures that are considered going orward must be subject to a cost-impact study to ensure that their expected benets outweigh the costs. Furthermore,measures that are demonstrated to be necessary must be designed so as to lead to moreharmonized rules across member states, globally.

InternationalSecurities LendingAssociation

In our view, the restrictions on short selling introduced since September 2008 havehad little or no eect on share price returns. But they have impaired market eciency,reduced liquidity, raised trading costs or investors, and created compliance costs ormarket participants. In addition, particular measures in some countries have causedpractical diculties or securities lenders and their agents.


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NYSE Euronext We believe that it is key to ensure that short selling does not constitute any abuse in itsel,and that regulatory intervention is justied in such cases only, i.e., where the level oshort selling results in market distortion or where it is a consequence o a market abuse.Short selling may indeed constitute an abuse in the case o knowledge o orthcomingevents like capital raising, or i the short position is accompanied by the dissemination orumours on a considered share. However, except in these circumstances, short selling is alegitimate investment technique that does not constitute any abuse per se and thereoredoes not require any intervention rom the regulators. Short selling can even improveliquidity and the price ormation process, hence enhance market eciency.

In these sensitive periods where short selling may constitute a market abuse (i.e., in thecase o capital raising or when there are rumours on a share), such abuses can be avoidedby taking the ollowing actions: either by ensuring transparency o investment rmsshort sales to the rest o the market; or by imposing the transmission o the relevantinormation on these trades, including OTC transactions, to the competent authorityduring the said sensitive periods. At NYSE Euronext, we consider that the second alternativewould be the most appropriate and practically ecient or all, i.e., the transmission tothe regulators o inormation on short selling done during sensitive periods. Indeed,this option would require minimum IT adaptations on the side o market participantsour systems already allow the inclusion o a specic eld in orders messages sent tothe regulated market. Moreover, this would allow the competent authority to undertakea systematic analysis o the trades declared short by intermediaries during the sensitive

periods o capital raising and in the case o rumours on a share.BME-SpanishExchanges

From the point o view o market microstructure, short selling covered by stock lendingcan contribute to increase the liquidity o the market as shown by some academic paperson the subject. This practice allows market participants to put in place dierent marketstrategies. The experience accumulated in the last months since the implementation omeasures restricting short selling all over the world has shown no evidence o impactin the price ormation o the stocks. Moreover, current restrictions lead the market to anasymmetric situation in a double bias. One is in the price ormation with less sellers andthe other is the obligation o inormation on short positions o certain stocks, whereasthis obligation does not apply to long positions. Measures on short-selling restrictionsshould be harmonized in the European Markets in order to prevent stricter systems romlosing competitiveness or being subject to regulatory arbitrage.

Hedge FundStandards Board(HFSB)

Short selling is a crucial component o an ecient capital market. Without it, investorswill be ar less condent about remaining invested and markets will be ar less ecient. Agood example o the inecient capital allocation that can occur when markets operatewithout correction is the wasteul investment in overpriced securities that is observableduring bubbles. The dotcom bubble o 1998/2000 or the house price bubble o 2005/2007provides ample evidence o this. Short selling is a crucial mechanism to burst bubbles,sometimes even preventing them rom happening. Notwithstanding these benets,we are aware that there can be cases o market abuse in the context o short selling.One such activity is called short and distort, where alse rumours are spread causing astock to all. This is similar to market abuse activity in the context o long positions suchas pump and dump. All such market manipulation is already illegal under current EUlegislation (Market Abuse Directive), and the HFSB has set out best practice standardsto help hedge und managers comply with these legal and regulatory requirements. It isimportant to note that the best practice approaches identied by the HFSB might wellmerit consideration or adoption by all investors in addition to hedge unds.

Union o ListedCompanies (ULC)

ULC does not support any regulatory banning o short selling. Short selling is a drivingorce or markets. What, however, needs to be regulated is the abuse o short-sellingpractices and the coordination o regulatory eorts. To that eect ULC believes thatthe ollowing measures should be considered: Strengthening transparency, Enhancingmarket integrity. An EU-wide market practice on short selling could be helpul to thateect, imposing all other practices that do not conront to such requirements to greaterscrutiny by the relevant authorities. Improving coordination and communicationbetween regulatory authorities should be established in case short-selling activities oan investment rm o one member state exceed specic thresholds in an issuer listed inanother member state.


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Page 16

THEORY EVIDENCE

RETURNSShort selling amplies price declines, taking the stockprices below their undamental value. An eectiveshort selling ban would reduce extreme negativereturns or restricted shares and also, possibly,increase average returns or restricted shares.

Behaviour o share returns did not change signicantlyater the introduction o the temporary ban. In the 15days ater a ban on short selling was introduced inthe UK, restricted stocks perormed better than theFTSE 350. However, in other periods, average returnsor the restricted stocks are generally in line with thereturns on FTSE 350 pre-ban and post-ban. In the30 days beore the introduction o the temporaryban, we do not nd evidence that short selling is

ampliying negative returns.VOLATILITYA ban on short selling would lead to lower volatilityor restricted share.

Volatility in the market has risen sharply ater theintroduction o the temporary ban on short sellingon September 18, 2008, but has come down to levelsobserved beore the introduction o the temporaryban.

LIQUIDITYLower traded volumes and higher bid-ask spread orshares on the restricted list to be expected.

Immediately ater the introduction o the temporaryban, trading volume or restricted shares increasedrelative to market. However, a marked decrease wasobserved later in trading volumes or the restrictedshares. Bid-ask spreads have increased market-wideater the introduction o temporary ban. However,spreads or the restricted stocks have increasedconsiderably more than they have or the market asa whole.

Source: FSA, United Kingdom

Several studies have evaluated the eect o the restrictions on short selling imposed by the US, the UK, andother major countries rom July 2008 onwards. A gist o the scope and outcome o these studies is given

below.

Marsh and Niemer (2008)Assessment o short selling restrictions, includingmean and median daily returns, their standard

deviation, skewness and kurtosis and their rst orderauto-correlation, and the goodness o t marketmodel o daily returns.

No strong evidence that restrictions on short selling inthe UK or elsewhere changed the behaviour o stockreturns. They also detect no sign that stock market

eciency declined as a result o the restriction.

Cliton and Snape (2008)Examined liquidity measures such as bid-ask spread,bid and ask depths, number o trades and volumestraded, and number o shares transacted, etc.

Ater the temporary ban, stocks on the restricted listhave lower liquidity compared to the control stocksand ater controlling or market-wide changes suchas increased volatility.

Bris (2008)Compared stock returns, rm undamentals, measureso market quality and pricing eciency, etc.

Share price perormance and market quality o theaected stocks are worse than that o comparablestocks prior to the ban. The aected stocks suered asignicant decline in market eciency.

Boehmer, et al. (2008)

Compare a selection o NYSE listed stocks on therestricted list with NYSE listed comparator stocks notsubject to the ban.

Stocks on the restricted list experienced a share price

increase at the start o the ban and a temporary shareprice decline when short selling resumed ater theend o the ban. However, market quality or thesestocks, as measured by spread, the ve-minute priceimpacts o trades and intra-day volatility, decreased.

Impact of Recent Short Selling RestrictionsAlthough short selling has long been controversial, the rationale or restrictions is quite oten contested. Anumber o empirical studies revealed that restrictions on short selling might not have led to the expectedoutcome.

In a discussion paper, Financial Services Authority, London, brings out certain important aspects o theregulatory restrictions in short selling on three most major aspects o the markets, namely returns, volatility,

and liquidity.


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Costs and BenetsEssentially, signicance o any regulatory measures is assessed in terms o the costs and benets. The FSA, in itsrecent consultations on the subject, also outlined the importance o costs and benets in each o the aspectso regulating or restricting short selling.

COSTS BENEFITS

Impose compliance costs on rms, such as legaladvice, adjustment o IT systems. The average initialcompliance costs associated with temporary ban

on short selling in the United Kingdom amountedto 40,000 pounds sterling per rm. Average cost ocomplying with the ban worked out to 6,500 poundssterling per rm. There are also certain indirect costsin terms o reduction in speed o price adjustment,liquidity and opportunity costs in the orm ooregone trading prots.

Eliminate risks associated with short selling, such asmarket abuse, disorderly markets, and settlementissues. A ban on naked short selling would reduce

the risk o settlement ailures brought about by theinability o naked short-sellers to source stock to ullltheir delivery obligations. A ban on short selling innancial sector stocks can, i complied with, eliminatethe potential negative eects o short selling in theseparticular stocks (market abuse, disorderly markets,and settlement issues). A ban will remove potentialconficts o interest or underwriters.

Current PositionThere are two schools o thought regarding the legitimacy o short selling as an activity and its impact on thedeclining stock prices. On the one hand, the votaries o short selling consider it as a desirable and an essentialeature o a securities market, not only to provide liquidity, but also to help price corrections in overvaluedstocks. In their view, the restrictions on short selling distort ecient price discovery, give promoters theunettered reedom to manipulate prices, and avour manipulators than rational investors. They argue that in adeclining market, short covering o positions opened at the beginning o the downturn, arrests the decliningtrend. They also bring a body o academic literature in strong support o their case or short selling. Further,in an ecient utures market, the relationship between spot price and utures price o the underlying asset isgoverned by cash-and-carry arbitrage and reverse cash-and-carry arbitrage. The latter requires that tradersshould be able to sell the underlying security short unless, o course, there is enough number o traders whoown the security and are able to sell it cash to take advantage o too low a utures price.

The critics o short selling, on the other hand, are convinced that short selling, directly or indirectly, posespotential risks and can easily destabilize the market. They believe that short selling can intensiy the decliningtrend in share prices, increase share price volatility, and orce the price o individual stocks down to levels thatmight not otherwise be reached. They also argue that declining trend in the share prices o a company caneven impact its und raising capability and undermine the commercial condence o the company. In a bearmarket, in particular, short selling can contribute to disorderly trading, give rise to heightened short-term pricevolatility, and could be used in manipulative trading strategies.

It is noteworthy that despite the conficting schools o thought, securities market regulators in most countriesand, in particular, in all developed securities markets, recognize short selling as a legitimate investment activity.Such jurisdictions also have an active market or equity derivatives, which include stock utures. Some o thejurisdictions even recognize the useulness o naked short selling in certain circumstances and, instead o

prohibiting short selling, the regulators have permitted it to take place within a regulated ramework. TheInternational Organization o Securities Commissions (IOSCO) has also reviewed short selling and securitieslending practices across markets and has recommended transparency o short selling, rather than prohibit it.

Boulton, Braga Alves (2008)Examined changes in the underlying market qualityor the stocks subject to the restrictions, includingliquidity, volatility, and the incorporation oidiosyncratic risk into stock prices.

The study reports a positive market reaction to theannouncement o the restrictions. The study ndsaverage cumulative abnormal returns o 12.9%or the restricted sample in the our trading daysbetween the announcement and implementationo the restrictions. However, over the our tradingdays ollowing the expiration o the order, the gainsassociated with the announcement period werepartially reversed, with the restricted sample stocks

experiencing a mean cumulative abnormal return o-5.2%.


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Page 18

Looking AheadThe IOSCO Technical Committee members have taken steps orreconrmed existing measures to minimize the possibility oabusive short selling at a time when the global credit markets areexperiencing signicant tightening. These measures include:

Conrm or impose new bans on naked short selling by requiringmarket participants to either borrow or make arrangements toborrow securities beore conducting short-sell transactions(in some jurisdictions this outcome was achieved with thecooperation o regulated or licensed exchanges), while ensuringthat bans on naked short selling do not negatively impact criticalmarket unctions such as securities lending.

Make it mandatory or certain investors to report short sellingor net short-sell positions to regulators, sel-regulatory bodies,or the public.

Conduct heightened surveillance o trading to detect abusiveshort selling.

Share surveillance inormation among members to addressabusive short selling.

The FSA is o the view that short selling is not in itsel manipulative.Rather, it is seen as a valid investment practice that, in essence,represents the opposite o taking a long position. However, shortselling, like any other orm o trading, may be manipulative, whenmisused.

The SEC is o the view that although the vast majority o shortselling is legal, abusive short-sell practices are illegal. For example,

it is prohibited or any person to engage in a series o transactionsin order to create actual or apparent active trading in a security orto depress the price o a security or the purpose o inducing thepurchase or sale o the security by others. Thus, short selling tomanipulate the price o a stock is prohibited.

The Secondary Market Advisory Committee o SEBI is o the viewthat genuine short selling could exacerbate price decline, but thatby itsel may not be construed as a manipulative activity unless thereare also evidences o market misconduct. However, the Committeeelt that abusive short selling practices to manipulate the price o astock will continue to be treated as market misconduct and attract

appropriate regulatory action.


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Annexure IRegulatory Actions Undertaken in Diferent Countries

United States

On July 15, 2008, the US Securities and Exchange Commission announced temporary restrictions on naked shortselling o the stocks o 19 nancial rms. This Emergency Order went on till August 2008. The US introduced aprohibition o naked and covered short selling or 306 nancial stocks on September 22, 2008. Ater October 8,

the ban only applied to naked short positions.

Regulation SHO

In the US, since January 2005, the SEC has done away with the age-old down tick rule, which was adoptedby the SEC in 1938. Tick rule gave way to Regulation SHO, which establishes two requirements called locateand close-out to address problems associated with ailures to deliver, including potentially abusive nakedshort selling. Locate requires a broker-dealer to have reasonable grounds to believe that the security can beborrowed so that it can be delivered on the due date o delivery beore a short-sell order in any equity securityis made eective. (This Locate must be made and documented beore the short-sell order is eective.) Theclose-out requirement imposes additional delivery requirements on broker-dealers or securities in whichthere are a relatively substantial number o extended delivery ailures at a registered clearing agency (thresholdsecurities).

It is not uncommon that trades remain unsettled on the stock exchanges in the US. The SEC recognizes atolerance level o unsettled trades or ve consecutive settlements, beore taking action under SHO. The newrequirements have been introduced in the wake o controversies arising rom trades remaining unsettled in theDepositories Trust & Clearing Corp. (DTCC) or several settlements as a result o naked short selling and ailedsettlements and circulation o countereit shares in a number o listed securities o small cap and in pink sheetcompanies.

United Kingdom

On September 18, 2008, the Financial Services Authority (FSA) introduced temporary short selling measures inrelation to stocks in the UK nancial sector companies on an emergency basis. It was done at a time o extrememarket turbulence, maniested in the orms o high and prolonged price volatility and downward pressure onthe prices o nancial stocks, in particular. There were concerns by the heightened risks o market abuse anddisorderly markets posed by short selling in these conditions. The temporary measures eectively banned theactive creation or increase o net short positions in the stocks o the UK nancial sector companies and requireddisclosure to the market o signicant short positions in those stocks. The FSA released a Discussion Paper onShort Selling.

India

SEBI reviews its regulatory policies periodically. The policy on short selling and securities lending and borrowingby the Secondary Market Advisory Committee has made some recommendations in this regard.

The Committee recommended that in the Indian context, short selling may be dened as selling a stockwhich the seller does not own at the time o trade.

Present regulatory restrictions, which allow only the retail investors to short-sell, should be removed to

enable a level playing eld or all classes o investors. In other words, the institutional investors who arecurrently prohibited should be permitted to short-sell.

The Committee recommended that in the Indian securities market, a securities lending and borrowingscheme must be put in place to provide the necessary impetus or short selling. The introduction o a ull-fedged scheme or securities lending and borrowing should be simultaneous with the introduction oshort selling by the institutional investors.

The Committee recommended that in the Indian securities market, naked short selling should not bepermitted and, accordingly, all investors would be mandatorily required to honour the obligation odelivering the securities at the time o settlement.


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The SMAC recommended that appropriate amendments be madewith a view to align the model agreements in the Indian securitiesmarket with the internationally accepted standards and also elt thatadequate disclosure o the lending and borrowing transactions tothe market was necessary.

JapanThe Financial Services Agency (FSA) o Japan has decided to takeadditional measures to strengthen the restrictions on short selling ostocks. The ollowing regulatory measures have already been takenon short selling with regard to all listed stocks in Japan:1. An uptick rule requirement that prohibits, in principle, short

selling at prices no higher than the latest market price.2. Requirements or traders to veriy and mark whether or not the

transactions in question are short selling.3. Request on exchanges to make daily announcements on their

aggregate price o short selling regarding all securities andaggregate price o short selling by sector.

In addition, the FSA has decided to prohibit naked short selling as atemporary measure (eective until March 31, 2009). It has also beendecided that holders o a short position o a certain level or more (inprinciple, 0.25% or more o outstanding stocks) will be required toreport to exchanges through securities rms.

Australia

The Australian Government introduced the CorporationsAmendment (Short Selling) Act 2008, which prohibits naked shortselling or all stocks including Exchange-Traded Funds (except nakedshorts in an underlying nancial product resulting rom the exerciseo an Options Market Contract). The Act also does not permit

covered short sales o all listed stocks (subject to a limited number oexceptions). Trading participants are required to continue to reporttheir net short-sell position or each stock to the Exchange on a dailybasis.The net short-sell position includes naked short selling in an

Salient Features o Securities Lending Scheme, 1997

The lender enters into an agreement with an approved intermediary (AI) registered with SEBI ordepositing the securities or the purpose o lending. The borrower shall enter into an agreementwith the AI or the purpose o borrowing o securities. The AI liaises between the lender and theborrower.

The AI shall guarantee the return o the equivalent securities o the same type and class to the lenderalong with the corporate benets accrued on them during the tenure o the borrowing. In case oailure o the borrower to return the securities, the AI shall be liable or making good the loss caused

to the lender. The AI retains the securities deposited by the lender in his custody as a trustee and shall lend the

securities deposited by the lender to the borrower rom time to time. The title o the securities lent to the borrower shall vest with the borrower and the borrower shall be

entitled to deal with or dispose o the securities borrowed in any manner whatsoever. The agreement between the lender and the AI and the borrower and the AI, shall provide or the

period o depositing/lending o securities, charges or ees or depositing/lending and borrowing,collateral securities or borrowing, etc.

The AI shall be entitled to receive ees or lending rom the borrower and collateral securities in theorm o cash, bank guarantee, government securities, certicate o deposits, other securities, etc.

In the event o ailure to return the securities, the borrower shall become a deaulter and the AI hasthe right to liquidate the collateral, in order to purchase equivalent securities o the same class rom

the market, or returning the securities to the lender. The AI shall be entitled to take any action, asdeemed appropriate, against the deaulting borrower to make good his loss, i any. The AI shall notiy deaults by any borrower to the Board, the concerned stock exchange, and the

concerned authorities or initiation o appropriate action against the deaulter.


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underlying nancial product resulting rom the exercise o an Options Market Contract and covered shortselling made by a trading participant, who is exempt rom the prohibition o covered short selling as per theAustralia Securities and Investment Commission.

Annexure II

Regulatory Approaches to Short Selling

Jurisdictions General approach Instrumentlimitations

Trading controls2 Disclosure

Australia Illegal to sell asecurity which theseller does not haveright to vest unlessunder exemptionapproved by theregulator

Liquid securitiesonly; no morethan10% perissue; not duringtakeovers

Tick rule Yes

Brazil No restrictions None None Stock lending

Canada 3 Permitted, subject

to reportingand marginrequirements, andtrading controls

None Tick rule Yes

France No restrictions None None No

Germany No restrictions None None No

Hong Kong Illegal to sell asecurity which theseller does not haveright to vest unlessexempted underthe law by the

regulator

Liquid securitiesand underlyingsecurities o aderivative andapproved ETF

Tick rule Yes

Italy No restrictions None None No

Japan Permitted subjectto trading rulesand marginrequirements

None Tick rule Yes

Malaysia Permitted on-exchange withpre-arranged stockborrowing 4

Liquid securitiesonly

Tick rule Yes

Mexico Permitted on-

exchange,subject to certainrestrictions

Higher liquidity

equities only

Tick rule Yes

Netherlands No restrictions None None Yes

Singapore Unrestricted, butexchange maysuspend individualsecurities ispeculative activityis excessive orabuse is suspected

None, unlesssecurity istemporarilydesignated asineligible

None No

Spain No restrictionsbut stock must beborrowed by theday o delivery

None None Stock lending


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Annexure IIIShort Selling across Countries

Country When

was shortselling

allowed

When was

securitieslendingallowed

Whether

shortselling ispractised

Comments

Argentina 1999 1991 No Equity lending is rare and occurs only betweenbrokers. Short selling cannot last more than 360days in a row. Only allowed or 16 stocks.

Australia Beore 1990 Beore 1990 Yes Securities can be borrowed rom ASX andcounter-party. Cash and non-cash collateral areaccepted at 105-110% o the underlying valueo the loan securities. Collateral is marked-to-market daily.

Austria Beore 1990 Beore 1990 Yes

Belgium Beore 1990 Beore 1990 Yes There is no organized market or stock lendingand borrowing. A law on securities lending waspassed in March 1999 but still pending. There isno ocial regulation on short selling stocks.

Brazil Beore 1990 Beore 1990 No CBLC has been authorized to maintain asecurities lending programme. Under CVMInstruction No. 249, only entities which oersettlement, registration, and custody services inthe Brazilian market are authorized to providesecurities lending services. Accordingly, oreigninvestors are not authorized to engage indirected/discretionary lending activities thatare outside the CBLC programme.

Canada Beore 1990 Beore 1990 Yes The market or securities lending is large (40+billion-dollar business) and well developed.

Chile Allowed in1999

Allowed in1999

No Short selling cannot last more than 360 daysin a row. The entity (including individuals) whois lending the stocks maintains the benecialownership, except the right to vote.

Colombia Not allowed Not allowed No Securities lending is not authorized.

Czech Republic Beore 1990 Beore 1990 Yes There is no regulations on short selling sincePrague Stock Exchange (PSE) was opened in1993. It is possible to sell securities only i absentsecurities are bought or borrowed beore thesettlement date.

Denmark Beore 1990 Beore 1990 Yes No regulatory barriers inhibiting securitieslending.

Finland Allowed in1998

Beore 1990 No The transer tax laws place a serious burden onthe activity.

Sweden No restrictions None None Yes

Switzerland No restrictions None None No

UK No restrictions None None Planned

US Permitted,subject to tradingrules, borrowingrequirementsand margin

requirements

None Tick and best bidrules

Yes

2. Markets/exchanges adopting tick rules generally provide various exemptions or market-making and a variety o hedging, risk

management or arbitrage trades. Strict adherence to an up-tick rule would otherwise make it impossible to carry out many trades wheretimely execution is critical, leading to reduced liquidity or increased risk.

3. This refects the regulations o the Canadian provincial regulators and exchanges/SROs.

4. Malaysia introduced a regulatory ramework or short selling in June 1996. This was suspended in September 1997 as one o several

measures to maintain market stability during the Asian crisis.


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France Beore 1990 Beore 1990 Yes Securities lending was permitted by law in 1987and 1988. All establishments (domestic andoreign) are eligible or short selling as long asthey are recognized as counter-parties.

Germany Beore 1990 Beore 1990 Yes A securities lending acility was created in 1989to improve market liquidity.

Greece Not allowed Not allowed No Securities lending and borrowing havebeen legalized by the Greek Parliament butthe operational ramework has yet to be

established.Hong Kong Allowed in

1996Beore 1990 Yes Short selling was allowed or 33 stocks in 1994,

and then to a wide range o stocks in 1996.

India Beore 1990 Beore 1990 No Not popular among market players. Not allowedor oreign investors.

Indonesia Not allowed Allowed in1996

No No guidelines have been provided by BAPEPAM,the Indonesian Regulatory Authority or theIndonesian Capital Market.

Ireland Beore 1990 Beore 1990 Yes Securities lending volume is still limited.

Israel Beore 1990 Beore 1990 No The TASE does not oer a securities lendingprogramme to its members. TASE rules indicatethat the securities account o a TASE member

at clearing house may not enter into a shortposition intentionally.

Italy Beore 1990 Beore 1990 Yes

Japan Beore 1990 Beore 1990 Yes Allowed or stocks listed on the rst section o the exchanges.

Jordan Not allowed Not allowed No

Luxembourg Beore 1990 Beore 1990 Yes

Malaysia Allowedin 1995,Prohibitedagain in1997

Allowedin 1995,Prohibitedagain in1997

Yes Short selling and securities lending weresuspended during the regional nancial crisis o1997. With the economic recovery, improvementsin report requirements, prudential controls andthe cessation o trading o KLSE-listed securities

oshore, short selling and securities lending areexpected to be restored.

Mexico Beore 1990 Beore 1990 Yes The system is generally used as a saeguardagainst ailing to deliver rather than securitieslending as a product. Foreign investors areeligible to participate in securities lendingthrough a local broker. Margin is 150%.

Netherlands Beore 1990 Beore 1990 Yes There is a central lending acility at the ASE.

New Zealand Allowed in1992

Not allowed No Tax regulations prevents onshore securitieslending rom taking o.

Norway Allowed in1992

Allowed in1996

Yes Securities lending is still in the early stages o development and tax implications are beingdiscussed at the Ministry o Finance.

Pakistan Not allowed Not allowed No There are no regulations that restrict oreigninvestors rom lending or borrowing securities.Short selling is not allowed

Peru Not allowed Not allowed No Oshore lending is prohibited. Lima Stock Exchange is considering allowing new activitiessuch as securities lending, short selling, and newrepo trades in the uture.

Philippines Allowed in1998

Allowed in1998

No Although the SEC has approved the rules on SBLand short selling, the rules are not yet clearlydened in the market.

Poland Allowed in2000

Beore 1990 No Neither the ull legal nor operational ramework have been established.

Portugal Beore 1990 Beore 1990 Yes Securities lending is allowed and practised.BVLP charges 10 b.p. annualized over the initialvalue (maximum days or calculation is 45 ) orthis service.


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Singapore Not allowed Beore 1990 Yes Onshore lending is limited while oshorelending is active.

SlovakRepublic

Not allowed Not allowed No Securities lending and borrowing is not allowedunder the Securities Act.

South Arica Beore 1990 Beore 1990 Yes Short selling is allowed in JSE.

South Korea Not allowed Beore 1990 No Securities lending and borrowing has not beenactive to date.

Spain Allowed in1992

Allowed in1992

No Securities lending and short selling have beenavailable since 1992. Since July 1994, SCLV hasbeen acting as principal or the lending poolormed by the daily bids rom the clearingmembers. The load must be reported to theSCLV within two working days o the sale date.

Sweden Allowed in1991

Allowed in1991

Yes Widely practised.

Switzerland Beore 1990 Beore 1990 Yes Securities lending is legal in Switzerland andthere are no restrictions on who may borrow orlend. There is no central lending acility and nostamp duties apply to securities lending.

Taiwan Not allowed Not allowed No Foreign investors are prohibited rom borrowingsecurities on-shore and can only lend securities

on-shore to brokers to cover their ails.Thailand Allowed in

1997Allowed in1999

Yes Short selling is very limited ater being allowedin 1999.

Turkey Beore 1990 Allowed in1996

No Securities lending is not widely practised.

UnitedKingdom

Beore 1990 Beore 1990 Yes Short selling is active in the UK.

United States Beore 1990 Beore 1990 Yes

Venezuela Not allowed Not allowed No Securities lending is not specically prohibitedor provided or under current regulations.Free transers o securities between dierentbenecial owners cannot be done without

executing a trade on the exchange. Oshorelending is generally not practised.

Zimbabwe Not allowed Not allowed NoSource: IOSCO

Note: Several changes in the rules governing short selling are being made in the period ollowing July/September 2008.This table presentsa general illustration o how the practice o short selling is treated in various jurisdictions. It is important to update the areas o practice asper the current guidelines.

Annexure IVExamples o Short Selling

The examples below illustrate some o the main uses o short selling.

They are presented in simplied orm and do not include, or example,any assessment o transaction costs. The nal example illustrates themarket risk to which a short seller is exposed.

1. Short selling on the view that a security is over-valued

An investor takes the view that the shares o Company A are over-valued. He short-sells 10,000 shares at the market price o 15 ashare. The investor completes the sale by delivering borrowed stock,enabling him to realise sale proceeds o 150,000.

Subsequently, the investor is proved right in his judgement and theprice alls. He decides to close out his position when the price alls

to 10. He then buys 10,000 shares (at 10 a share), or which hepays 100,000 in total. He uses these shares to close out his stockborrowing obligations and is let with a gross prot o 50,000,beore any transaction costs.


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2. Short selling as part o a long/short strategy

An investor, possibly uncertain about the likely trend o the market, in general, decides to pursue a strategy thataims to capitalize solely on changes in the relative pricing o securities.

The investor decides that the shares o Company A are likely to outperorm those o Company B, irrespective ohow the market as a whole perorms.

He invests $200,000 in Company A and goes short o shares worth $200,000 in Company B.

Over the next ew weeks, Company As share price rises 10% and that o Company B rises 2.5%. On closingthe position, the investor thus realises a $20,000 (i.e., 10%) prot on his long position in company A, but loses$5,000 (i.e., 2.5%) on closing out the short position in company B.

Overall, the investor realises a gross prot o $15,000 gross, beore any transaction costs. I both share priceshad allen rather than risen, the investor would still make a prot provided the price o Company Bs sharesall by more than that o Company As. For instance, i the price o Company As shares ell 2.5% (creating aloss o $5,000) but that o Company Bs ell 10% (creating a prot o $20,000), the overall prot would also be$15,000.

3. Hedge o a short derivative

A securities rm sells an investor a put option in the shares o company A, giving the investor the right to sell

the securities rm 100,000 shares at 10 a share at some point during the next 90 days. The shares are currentlypriced at 11 and the investor has paid 25p a share or the option in total 25,000. I the price alls and theinvestor exercises its option, the rm will lose money i it cannot resell the shares or more than 9.75 itspurchase price, less the 25p a share it has received as premium.

Suppose in this case the Company A is aected by unexpectedly bad news and that the share price startsalling, exposing the investment rm to an increasing likelihood that the customer will nd it attractive toexercise its put. To protect itsel, the investment rm goes short 100,000 shares in Company A when the pricereaches 10. It borrows the shares to deliver to the buyer and the sale realises 1 million. Shortly ater, theinvestor exercises his option and requires the investment rm to buy his 100,000 shares at 10 a share or 1million in total. The investment rm uses these shares to return to the stock lender and is let with its 25,000intact (beore expenses).

4. ArbitrageAn investor notices that a convertible loan stock with the right to convert into ten shares o Company A orevery 100 nominal o convertible is selling at only 95 per 100 nominal and that the shares o Company Aare trading at 10 a share. Even though the convertible appears cheap, the investor does not know i the shareswill rise or all beore he can convert. However, he can lock in a prot regardless o the movement o prices bybuying the cheap asset and selling the dear one.

He, thereore, invests 95,000 in buying 100,000 nominal o the convertible and simultaneously short-sells10,000 sharesthe number o shares into which his convertible holding will convertat the current marketprice o 10 a share. Since at that time he has no shares to deliver, he needs to borrow them. On delivery, herealises the sale proceeds o 100,000.

When the investor subsequently exercises his conversion rights and takes delivery o 10,000 shares, he usesthese shares to close out his borrowing, leaving him with a guaranteed 5,000 prot (beore expenses).

5. A bear squeeze

In this case, an investor takes the view that Company A will report worse earnings than the market expects andthat its shares, currently priced at 5.00, are overvalued. He short-sells 100,000 shares at that price, realising500,000. The price initially weakens to 4.75 as rumours circulate that the stock is being short-sold. Newspeculation that the company may be vulnerable to takeover suddenly reverses the trend. The more proessionalmarket operators also know that any short-sellers will want to close out their positions and will need to chasethe price higher to do so. They see that they can make money squeezing the bear. The price rises over the nextew days to 5.50 and the short-seller completes the close-out o his short position by purchasing 100,000shares at an average price o 5.25 or 525,000 in total. His loss beore expenses, thereore, totals 25,000, butmight have grown still larger i he had not closed out and a bid battle or the company had commenced.


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