The UK-based Alternative Investment Management Association (AIMA) has prepared its response to the discussion paper on short selling put out by UK's regulatory watchdog, the Financial Services Authority.
AIMA's response was prepared by a working group consisting of members of AIMA in the alternative investment management sector in the UK and has been approved by the Council of AIMA on behalf of its membership.
Summarising its response, AIMA stated: "Our members believe that short selling is an integral part of developed markets and that it leads to greater market efficiency. It also improves market liquidity, a particularly important feature at times of market extremes, when hedge funds tend to be market contrarians, "buying when the market is selling and selling when the market is buying".
"It is worth noting that every short ultimately must be covered, thus leading to a purchase. Consequently, from an economic and market perspective, the role of short selling is clearly beneficial and not to be prohibited or unnecessarily restricted. The question therefore arises as to whether additional information is necessary for the regulator to determine whether the practice of short selling may have a detrimental (organised or systematic) effect on the value of individual stocks and shares."
"It is important to be aware that there is a disequilibrium of risk between long and short positions: a long holder of stock can only lose the current value to zero, while a short holder in a "bear squeeze" has an unlimited loss profile. Therefore, disclosure of the information as to shorts cannot be treated the same as information as to longs."
"There is no evidence that short selling activity is greater when markets have sustained a prolonged decline than when they were at historic highs....We believe that further consultation on the detail of any proposals and on draft legislation will be necessary".
AIMA added: "We intend to contribute to such further consultation. In advance of that, we are very willing to discuss with the Financial Services Authority any items on which it seeks additional information or views."
The following are some key questions posed by the FSA, followed in each case by AIMA's responses to them:
FSA: Could the current business regime (covering short selling) be improved in any way?"
AIMA: Were any modifications to the Rules to be introduced, they should logically encompass derivatives to avoid those being circumvented.
They should also apply to all, including banks, and not just to hedge funds.
An alternative and simpler process would be to require disclosure by prime brokers of the level of their lending per stock; that would involve fewer parties (all of whom are regulated) and would include derivatives.
FSA: Would you consider it necessary to capture all short positions in all derivatives markets, including the non-exchange market (over-the- counter market)?
AIMA: We believe that the capture of such information is a considerable and very complex task; it would also be more costly and particularly difficult to implement. Clearly, if full transparency is to be achieved, then it should extend to derivatives, such as CFDs, the preferred instrument for most hedge funds seeking to short UK securities. We would, however, query the practicality and the cost of the exercise.
We therefore think it might be more practical to work under a modified form of information provision if this Option 2 were to be utilised. This may provide the required level of market information that the FSA needs.
One suggestion might be to conduct a trial without any onerous documentation or bureaucratic attachments. The value of this information is usually its timeliness and it is probably more important to get a view concerning focused and heavy shorts than an overall absolute market number of shorts on a time-delayed basis.
FSA: How would the information about derivative short positions be useful?
AIMA: On the assumption that the physical short positions do not give a complete picture, then information on the derivative short positions would give a more comprehensive or meaningful picture of the overall position.
FSA: What feedback can you give us on the possible cost implications?
AIMA: At this stage, one should be somewhat cautious of cost benefit analysis studies. The usual sceptical reason for this is that the cost of the analysis is usually high and the benefits low. It is probably useful for the regulator to have an idea of short positions if this is supported by a full understanding of OTC created (derivative) shorts. Otherwise, such information in isolation is probably not that useful.
The cost if derivatives were included would be greater. Many hedge funds are not profitable at current levels and this restrictive option would discourage short selling and make markets less efficient.
FSA: Do you consider that a market disclosure of short positions is warranted?
AIMA: Since short selling does not confer any legal rights or title (e.g., votes or dividends) with respect to the underlying company, it is, therefore, not evident to us why the terms of the Companies Act, 1985 should extend to a large percentage of short positions. Thus, we consider this to be a market issue, rather than an issue as to company law.
Stocks trading at low volume can be more easily manipulated, so a percentage threshold for disclosure seems a logical step.
Disclosure of large short positions (5 per cent plus) to the company and disclosure of directors' dealings in short sales are acceptable but not disclosure of short sales in specific situations; that would interfere with the investment process too much, be difficult to administer and provide information that would be useful only to the "front runners".
It could drive short sellers from the market, which is not in the public interest. With regard to the statement that market users as a whole would benefit from knowledge of large short positions, we consider that they would only do so in order to engineer a "bear squeeze".