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Money managers under the microscope

Short selling – remember that one?

May 13, 2009

Plenty has happened since the UK brought in its temporary ban on short-selling financial stocks last year — Madoff, Weavering, hedge fund outflows, the EC’s controversial plans for hedge fund rules, and even a few hedge funds making money.

rtxbqwlHowever, behind the scenes, the debate on how to handle this controversial practice rumbles on, and today the Investment Management Association published its response to the FSA’s discussion paper, now that the period for responses has closed.

Much of it is as expected — a strong defence of short selling, highlighting its role in investment management, risk management, providing liquidity, cutting transaction costs and helping to ensure price efficiency — but there are some points to pick out.

For instance, the IMA believes no justification for banning naked short selling — a particularly controversial practice whereby someone shorts a stock without first borrowing it or ensuring they can borrow it – has yet been made, pointing out that the level of failed trades on the London Stock Exchange is very low, “with few of those that do occur being identifiably linked to naked shorting”.

It also puts forward a forceful argument on transparency, arguing disclosure to regulators is “an important check on the markets” but that wider disclosure to the market could cause problems.

“Firms which do this work (research on shorting a stock) should not have their valuable conclusions given away free to others,” says the IMA, arguing short sellers are less likely to put in the work, meaning liquidity is reduced, pricing will be less accurate and “bubbles will continue for longer than they would otherwise”.

“I am … most disappointed that there is no real discussion of the benefits or costs of market transparency in this paper, which, in my view, fatally undercuts the arguments put forward in favour of transparency,” says IMA regulatory adviser Adrian Hood.

Meanwhile, those who do put on short positions that are then disclosed could see ”free-riders” pile in afterwards, the IMA says, pushing down the stock’s value and increasing volatility.

The debate about whether or not short selling was driving down some banks’ share prices erupted last year at the nadir of the financial crisis. Ironically, if the optimism of the past two months, and the predictions of a possible new bull market by Crispin Odey and Anthony Bolton, are correct, it may no longer be such a controversial issue by the time the FSA draws its conclusions.

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