Australian Short Selling
Australia Drafts Short Selling Regulation
The Australian Treasury are seeking comments on their short selling exposure draft. The current legislation around short selling is complex and unclear and the absence of reporting covered short selling has heightened uncertainty about its real impact and contributed to a 30 day temporary ban being imposed on 21 September 2008.
I believe that concerns about the impact of short selling on the general level of sharemarkets is overstated, and that while there are benefits in producing clearer legislation in the area, it will do little to address the current difficulties facing the Australian and global financial systems.
I am concerned that para 14 says "The Bill will replace ASIC's interim reporting requirements for covered short sales ..." If the temporary ban on short selling remains in place until the Bill becomes an Act, then the Australian financial system will be seriously impacted in the meantime.
Notwithstanding these high level comments, the draft is well balanced and shows a good understanding of the issues. I note para 16 in particular which says that "The Government is not seeking to prohibit or discourage covered short selling activity." That's good.
The draft distinguishes between naked and covered short sales. This distinction is relevant in relation to the current interpretation of the reporting requirement for short sales. Beyond that, a short sale is a short sale and the economic impact of being naked or covered is not relevant. This is a red herring in the argument.
Para 16 uses stock lending activity to estimate an upper limit of short selling in Australian listed securities of 4%. It notes that stock lending can be used for other purposes than short selling. However, there is no discussion of the likelihood that stock lending transactions may pass through many hands (it is a deep and liquid market) before it finally reaches a short seller. I have no evidence to support this, but typically a fund manager will ask their prime broker for stock availability. The prime broker may draw the stock from their own/their client's inventory or go to the market to borrow the stock for the manager. To the extent this occurs, stock lending activity will further overestimate short selling.
Para 22 argues that the absence of transparency in short selling may adversely impact investor confidence and market integrity, increasing the cost of capital and reducing investment activity. I would argue that the absence of short selling brought about by the temporary ban will also have this impact.
Para 23 discusses objectives. The first two points are side benefits to investors, but are inappropriate as objectives for any legislation. Providing information that is hard earned by one set of participants freely to others is unfair and unbalanced. In the case of the first point, "to provide a signal that individual securities may be overvalued", assumes that short sellers are better judges of share value than other investors ie those holding the investments long. This is not necessarily the case. If it is the case, then why should legislation be introduced that makes it easier for poorer judges of value?
The discussion of gross or net reporting of short sales is not relevant. Only net short selling will have an economic impact.
The main weakness of option two (para 26) is that reporting will be made on a trade basis. This implies a significant accounting requirement to follow through the impact of the sale on existing positions and to correct for any trade failures etc. Is the position opening a new short sale, extending an existing, reducing an existing ie a purchase.
It will be more straight forward to report positions and not trades at designated points of time. This information should be published from the source of truth, which is not the trade advice received by the broker. Typically brokers do not carry a record of holdings for their clients and investors may use multiple brokers to achieve a desired position.
I believe the best source of this information is held by the investor or as is generally the case, the investor's agent, the custodian or sub-custodian. Custodian's that carry short positions on behalf of clients already capture, settle and report this data daily on a traded and settled basis. Positions will also include off-market transactions for which they act as custodian. There are fewer custodians, than either investors or brokers. This alternative was not mentioned at all in the exposure draft, but is likely to be the preferred route and impose lowest regulatory cost.
Also not mentioned is that Short Interest has been captured in other markets for some time. In the US, Short Interest is published by major exchanges fortnightly eg http://www.nasdaq.com/aspxcontent/shortinterests.aspx?symbol=MSFT&selected=MSFT shows Microsoft's Short Interest history. What is the process employed in these markets? Can it be applied in Australia?
Will there be areas of activity not captured by using custodians? Offshore investors will presumably use sub-custodians. Users of direct market access systems will report trades to their custodian for setlement. Broker's principal positions? Anything else?
Para 34 discusses the problem of different trading desk activity in the same firm. Using the custodian approach, each account will be aggregated across every security. The fact that some houses will have offsetting long positions is not relevant. The fact that one group in the house has borrowed stock (or sold in advance of borrowing stock or settling) as principal or for a client is what is required to be captured, and will be captured using this approach.
Para 34 also discusses whether short sale reporting should be delayed. The concern presently is that the data should be provided frequently and quickly as it is believed to be materially important. However, international experience is that data provided fortnightly serves the market well. In fact, there is little movement from one fortnight to the next. But where there is a commercial advantage for short sellers in those markets, I believe it is sufficiently preserved with this level of periodic reporting.
In summary, the use of brokers to collect short sale trade information at the point of the trade is not the most effective way of achieving the desired outcome. Periodic position reporting by custodians, and investors that do not have custodians, is likely to provide adequate transparency of short selling in Australian securities.
Guest post by Rick Steele
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