By Neil Wilson
Was it ever thus? Perhaps it is simply human nature to seek a
scapegoat. Certainly, it seems that whenever the markets are in
freefall and losses are leaving blood on the Street, there is a
scramble to find somebody to blame. And who are the usual
suspects? The hedge funds, of course - those bad guys
mercilessly shorting the hell out of stocks.
Such was the case the last time markets plunged - in the
wake of the tech bust, when equities fell more than 40% from
2000 to early 2003. During that period, many listed companies
and long-only investors complained loudly about hedge fund
behavior, and some institutions even withdrew from the
stock-lending market to try to frustrate the short sellers.
And it is the case again, this time around, in the wake of
the credit crunch. Only this time, the regulators seem to have
gotten caught up in the hysteria, too - with counter-productive
and potentially damaging consequences.
In the United States, the Securities and Exchange Commission
imposed emergency rules this summer to restrict naked short
sales in certain financial stocks and issued subpoenas to a
long list of firms requiring information on short-selling
activity. And in Britain, the Financial Services Authority made
two moves - requiring disclosure of short positions on stocks
undertaking a rights issue, and requiring disclosure of
"synthetic" long positions held via contracts for differences
There was arguably nothing wrong with either of the FSA's
actions. Sizable short positions should quite rightly be
disclosed just as much as sizable long positions - though the
FSA requiring disclosure when a manager holds only 0.25% or
more on the short side does not seem quite equivalent to the
long side (where disclosure is required only at 3% or more).
Arguably, it is also right that large positions held in CFDs -
often held simply for reasons of tax efficiency (so that a fund
avoids paying the stamp duty transaction tax) but also
sometimes perhaps for sheer anonymity - should be just as
reportable as outright stock positions.
But what was wrong, certainly with the rule change on
disclosure of short positions, was the way it was pushed
through in such a hurried way. Normally, if a regulator is
contemplating a rule change, there is a process. Once a
proposed new rule is published, comments are sought from the
industry during a consultation period, amendments are usually
then made, and finally the new rule is implemented.
Britain's rule change on shorts did not adhere to this
process; instead, the proposed change was announced and
enforced within a matter of days - allowing no chance for the
industry to make considered comments or lobby for amendments.
And why was that? One reason the regulator gave was that in a
highly stressed market, the FSA had to guard against greater
potential for market abuse.
But it seems to me hard to escape the conclusion that the
perilous conditions in the markets had driven the regulator
into a state of panic. As the head of one leading hedge fund
group in London put it to me, with a strong note of
indignation: "What market abuse? What evidence of market abuse
is there?" No evidence of market abuse has come to light so
And what has been the effect of the change? Perhaps the ends
would have justified the means - if the FSA's move had indeed
calmed the turbulent markets.
But instead, the results appear to have been contrary to
intentions. In the case of the recent rights issue by HBOS,
Britain's biggest mortgage bank, forced disclosure by major
short-sellers only served to confirm that strongly performing
hedge fund groups, such as Harbinger and Lansdowne, were indeed
short HBOS during its battle to raise roughly $8 billion in new
equity. And the market seems to have concluded that, if smart
guys like them were short, maybe it wasn't worth backing.
In any event, HBOS stock continued to languish below the
offer price after the disclosure rules came into force, and the
rights issue was a massive flop. Less than 10% of the offer was
In a short space of time, therefore, the FSA appears to have
put in jeopardy its hard-won reputation as a sophisticated
regulator that understands hedge funds. After all, markets
require buyers and sellers in order to function smoothly;
active traders, as many (if by no means all) hedge funds are,
make markets a lot more liquid; and markets benefit in
particular from natural buyers when prices are falling - which
is the way short sellers take profits.