Short selling has been blamed -- rightly or wrongly -- for how rapidly share prices of financial institutions, especially in the US, deteriorated post-Lehman Brothers' collapse. The knee-jerk reaction in markets such as the US, the UK and Australia was to ban short selling. In Asia, Taiwan and Korea followed suit. Markets such as Hong Kong, Japan, and Thailand didn't change the rules.

The impact of short selling and the response from regulators has led to some soul searching about how to treat these trades and whether tougher regulations are indeed necessary.

The International Organisation of Securities Commissions' (Iosco) technical committee has just published a consultation report on the regulation of short selling. The report -- prepared by the taskforce on short selling chaired by Hong Kong Securities & Futures Commission CEO Martin Wheatley -- contains proposed principles designed to help develop a more consistent international approach to the regulation of short selling.

Iosco is recognised as the leading international policy forum for securities regulators. The organisation's membership regulates more than 95% of the world's securities markets and Iosco is the international cooperative forum for securities regulatory agencies. Iosco members regulate more than one hundred jurisdictions and its membership is steadily growing. Members comprise of 100 countries including the US, the EU's 27 member states, Japan and Hong Kong. 

Iosco's taskforce on short selling was established by the technical committee in November 2008 in response to concerns regarding the impact that short selling was having in markets worldwide. The taskforce's aim was to work to eliminate gaps between the different regulatory approaches to naked short selling -- whereby a dealer sells shares in a company without borrowing them first -- while minimising any adverse impact on legitimate activities, such as securities lending and hedging, which are critical to capital formation and reducing market volatility.

The report recommends that effective regulation of short selling should be based on four principles: short selling activities should be subject to appropriate controls to reduce or minimise the potential risks that could affect the orderly and efficient functioning and stability of financial markets; short selling should be subject to a reporting regime that provides timely information to the market or to market authorities; short selling should be subject to an effective compliance and enforcement system; and short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development.

Iosco is gathering responses to its consultation paper on short selling until May 4.

Kathleen Casey, chairman of Iosco's technical committee, says the group believes that short selling plays an important role in capital markets for a variety of reasons including more efficient price discovery, mitigating price bubbles, increasing market liquidity, facilitating hedging and other risk management activities. However, she notes that there is also a general concern that, especially in extreme market conditions, certain types of short selling or the use of short selling in combination with certain abusive strategies may contribute to disorderly markets.

"These principles have been developed with a view to striking a balance between realising the potential benefits of short selling and reducing the adverse impact on financial markets that may arise from abusive short selling," says Casey. 

For his part, Wheatley says that short selling should operate in a well-structured regulatory framework in the interests of maintaining a fair, orderly and efficient market. He says the objective of regulation should be to reduce the potential destabilising effect that short selling can cause without exerting undue impact on its legitimate benefits in capital formation and volatility reduction.

"While Iosco encourages a concerted move towards a consistent approach to short selling, it recognises that the case for the regulation of this activity varies from jurisdiction to jurisdiction and depends on a range of domestic factors," Wheatley says. "These principles will provide guidance to market authorities and assist them in assessing and developing their short selling regulatory framework."

In reaction to the Iosco report, Aima -- a global trade body for the world's hedge fund industry -- says a more consistent approach to the regulation of short selling would be ideal. At present, many discrepancies worldwide create unnecessary uncertainty, Aima says.

Aima believes short selling is a wholly legitimate market practice, is not abusive and helps capital markets function more effectively.

Aima agrees there should be appropriate reporting regimes for disclosing short positions to national regulators, but that any reporting of short positions be done in aggregate form only. Aima also supports measures to reduce short selling settlement failures.