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ôWe began to research this issue about three months ago when short selling appeared to be a side issue to the credit crisis,ö says David Smith, Singapore-based director of corporate governance research and author of the report. ôNow itÆs a major issue.ö
He says Hong Kong has the most robust regulatory system regarding short selling in the region, and globally. But it can yet improve, particularly regarding disclosure requirements.
The past month has seen ad hoc, piecemeal restrictions placed on shorting in the United Kingdom, the United States, Australia and other jurisdictions. Smith says these headline-grabbing events (and the related demonisation of shorting in the popular press) is distracting the industry from the true issue: the disclosure and regulation of short selling.
Because Hong KongÆs existing rules are good, the territory has so far not experienced the highly volatile waves of shorting that prompted other regulators to impose bans. As the dust settles, therefore, Hong KongÆs system should be seen as the new global standard. But it does have flaws, and addressing these would not only help Hong Kong, but strengthen this global model.
Regulations vary among jurisdictions about the level of disclosure required. Smith says the overriding concern regarding the practice is the asymmetry of information disclosure between and within markets, and between types of trades. There is a lack of disclosure of trading volumes, by stock or by market; whereas long investors must reveal ownership over a certain threshold, no such rules govern short investors; naked short selling (which is banned in Hong Kong) is impossible to detect because it evades any reports put out by stock lenders.
Access to decent information would allow stock lenders to better price their loans; give companies a warning that their share price is under attack, particularly at sensitive times such as raising funds for an acquisition; and would enhance short sellingÆs overall reputation.
Other issues involve whether stock lenders will lend out stock taken as collateral from other borrowers. Smith documents cases in Singapore and Australia where securities lent out could not be returned when there was a squeeze on supply, or when debtors seized the lenderÆs assets, including securities it held as collateral. Had the corporate lender who posted collateral realised what was going on, it could have taken steps to protect itself.
130/30 funds are becoming an added complication, Smith says. These funds, which sell short a percentage of their portfolio in order to extend their long positions with the proceeds, are usually constructed using traditional portfolio techniques. But some fund management companies are now allowing the borrowed securities for the short side to come from securities held in their long-only portfolio, a practice called in-house originated short selling, or synthetic stock lending. It is currently legal and beyond any regulatory disclosure or oversight.
Smith argues Hong Kong can enact several measures to improve its system. First, harmonise its existing disclosure rules. In Hong Kong, investors must only disclose a short position if it is over 1% of the portfolio and the portfolio also has more than a 5% long position in the company. This has led to the bizarre result in which companies with no long positions can short as they please, and not have to report it (same for portfolios with less than a 5% long exposure). Smith argues that all short positions greater than 1% should be disclosed, regardless of long interest.
Second, he suggests Hong Kong mandate daily notification of open short positions; today, short sales must be disclosed but the market doesnÆt know when a short has been closed. The exchange should collect and publish this data, as it is done in Australia.
Third, Hong Kong should explicitly write a provision to enable it to remove certain stocks from eligible short lists under certain circumstances (say a certain threshold of a stock price decline). The regulators have the authority to do so but there are no rules governing this; clear rules would help communicate to the market when a particular stock was coming under major short-selling pressure.
Fourth, Smith says Hong KongÆs exchange should collect and publish the level of aggregate stock loans by company; making sentiment more transparent will allow market participants to price trades accordingly.
Lastly, he says Hong Kong should coordinate its rules closely with mainland China, which is now launching a pilot scheme for short selling, to avoid potential arbitrage and manipulation via QFII and QDII regimes.
For those investors who hate the idea of disclosing their short positions, Smith says: ôAs long as short selling lacks transparency, short sellers will continue to be pariahs during market declines, taking the blame for excessive swings and crashes.ö
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