Our never-ending short selling debacle: Kohler

All short selling is banned; it is as banned as insider trading and armed robbery. In Australia, regulatory guide 196 says: “A person may only sell (financial products) to a buyer if, at the time of sale, the person has a presently exercisable and unconditional right to vest the products in the buyer.”

So why do we keep talking about short selling that is permitted, and why did ASIC have to extend the ban on short selling of financial securities last week, while continuing to permit short selling of other stocks?

Because we’re not talking about short selling at all – we’re talking about stock lending, which temporarily transfers an “unconditional right to vest” to someone else under a securities lending agreement.

In effect, stock lending creates extra shares in a company, just as money lending swells the supply of money. The lender remains registered as the owner of the shares, but someone else also “owns” the same shares under a stock lending agreement. The shares therefore multiply like bacteria and the selling is not short.

“Naked short selling”, in which you simply sell what you don’t own and then fail to deliver on time, also goes on – like all illegal activities. In the United States the SEC publishes “fails” (events of failure to deliver at settlement) so you can get an idea how much of it there is; in Australia we are protected from such frightening information, and assured that it doesn’t happen at all.

Before the collapses of both Bear Stearns and Lehman Brothers, there was a sharp increase in the number of “fails” in their shares – that is, they were attacked by short sellers. As a result, US campaigners against short selling claim that naked short sellers have basically caused the global financial crisis and recession, which is impossible to prove.

In Australia, financial stocks like Macquarie Group have tanked despite the ban on short selling (that is, stock lending) of financials. What is the settlement fail rate on these stocks?

Back to covered short selling, or stock lending. It seems bizarre to me that we have not had a decisive debate about its regulation and, indeed, its existence, especially with the continuing debacle of Opes Prime.

Money lending is a highly regulated activity. Those who do it must be licensed and must hold a certain amount of capital as a buffer against loss.

As we are now learning for the umpteenth time, the lending of money – AKA the credit creation process – is necessary for economic growth.

We know that because credit creation has now stopped because too much money had been lent simply to buy land instead of productive assets, thereby temporarily and artificially inflating the price of land and then dissolving bank capital as prices fell. As a result, economic activity has now stopped as well.

But why is it necessary to lend securities? The “creation” of extra shares only results in their sale. The borrowed shares are never used for productive activity, as credit is; they are only used to profit from a destruction of value.

That’s because stock lending increases the supply of an asset and naturally tends to depress its price. The borrower aims to profit from that fall in price by selling and then “covering” (buying back) later.

The lender is paid a few basis points for the loan, but is behaving absolutely rationally.

That’s because institutional investors are all judged according to relative performance. If an institution lends stock, which causes the price to go down, it will perform relatively better than its peers because it got a few extra basis points, whereas its competitors simply cop the full reduction in price.

If fund managers and super funds were judged purely on absolute performance, stock lending would not exist because the “interest” amounts earned on the loans do not cover the falls in price that are caused when the lent stock is sold.

It’s true that when the “cover” takes place – that is, when the borrower repays the loan and counts the winnings – the supply of the stock shrinks again and the price tends to go up.

But the whole thing is a temporary distortion of the market. The market operator – the ASX – loves the system because it increases the supply of shares available to trade, so it makes more money. ASIC seems to be wringing its hands. The politicians are largely oblivious.

The proponents of stock lending say it increases liquidity, but that is a tautology– it is simply saying that more of something produces more of a something.

The question is whether artificially increasing the supply of listed securities through stock lending is necessary for the better functioning of the securities market and the economy.

Let’s have that debate.

 

This article first appeared on Business Spectator

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