The Market Practice Of Short Selling Stocks

Published Date: 02 Nov 2017

Presented by

Andrew Sciberras

A dissertation presented to the Faculty of Economics, Management and Accountancy

Submitted in partial fulfilment of the requirements for the Degree of Bachelor of Commerce Banking and Finance (Honours) at the University of Malta

May 2013

ABSTRACT

This dissertation examines the often controversial market practice of short selling stocks. In particular, the study provides an understanding of the possible effects short selling could have on stock prices and financial markets, together with how short selling transactions are conducted, the motivations behind them and the risks faced by those who engage in short selling.

The study also presents an insight on the local scenario, where the perception towards the practice of short selling on the Maltese Stock Market is assessed through a questionnaire circulated among various market players.

Keywords: Short Selling; Effects; Motivations; Malta

Dedicated to my family.

ACKNOWLEDGEMENTS

My first expression of gratitude goes to Mr. Tony Camilleri, my tutor, for his assistance and guidance throughout the completion of this dissertation. Special regards also to representatives within the Hedge Fund industry, the Malta Financial Services Authority and the Malta Stock Exchange for their assistance in issues related to the local stock market. I would also like to thank all those individuals (and their representing companies) who provided responses for the questionnaire as this was an integral part of the dissertation.

DECLARATION OF AUTHENTICATION

I hereby confirm the originality of the dissertation entitled ‘The Market Practice of Short Selling Stocks’, which was written and submitted as partial fulfilment of the requirements for the degree of Bachelor of Commerce Banking and Finance (Honours) in May 2013.

I also confirm that all reference sources have been duly cited and any help received has been appropriately acknowledged.

Andrew Sciberras

Table of Contents

CHAPTER 1 INTRODUCTION 1

1.0 Introduction 2

1.1 Objectives of the Dissertation 4

1.2 Dissertation Structure 5

CHAPTER 2 LITERATURE REVIEW 7

2.0 Introduction 8

2.1 Positive Effects of Short Selling 8

2.2 Negative Effects of Short Selling 14

CHAPTER 3 OVERVIEW OF SHORT SELLING 22

3.0 Introduction 23

3.1 What is Short Selling? 23

3.2 The Players 29

3.3 Motivations for Short Selling 32

3.3.1 Speculation 32

3.3.2 Hedging 32

3.3.3 Index Arbitrage 33

3.3.4 Merger (Risk) Arbitrage 33

3.3.5 Market Making 34

3.3.6 Taxation: Shorting against the box 34

3.4 Risks 35

3.4.1 Unlimited downside risk 35

3.4.2 Recall risk 35

3.4.3 The Up-tick rule 36

3.5 Conclusion 38

CHAPTER 4 RESEARCH METHODOLOGY 39

4.0 Introduction 40

4.1 Secondary Information 40

4.2 Primary Information 41

4.2.1 Questionnaire 42

4.2.1.1 Structure of the questionnaire 43

CHAPTER 5 AN ANALYSIS OF THE MARKET PRACTICE OF

SHORT SELLING ON THE LOCAL STOCK MARKET 44

5.0 Introduction 45

5.1 Short Selling in Malta 45

5.2 Interpretation of Results 47

5.2.1 Respondents 47

5.2.2 Findings 48

5.3 Conclusion 62

CHAPTER 6 CONCLUSION 63

6.0 Introduction 64

6.1 Summary of Main Findings 64

6.2 Research Limitations 66

6.3 Suggestions for Future Research 67

6.4 Conclusion 67

REFERENCES

APPENDICES

Appendix I: Questionnaire

LIST OF FIGURES

CHAPTER 1

INTRODUCTION

Introduction

Rational investors seek to maximise their returns whilst incurring the least possible risks. The buying and holding of securities for a long period of time represents the most common investment strategy adopted by investors. Such investors normally expect to earn dividends from the purchased stocks, bonds or mutual fund shares.

When allowed, stock markets offer investors another tool to earn profits and manage some risks: Short Selling.

This investment strategy allows market players to profit from the decline of stock prices and normally involves the borrowing, selling and subsequent repurchase of a particular company’s stock. The investor makes a profit if the repurchase price is lower than the original selling price.

During the recent global financial crisis, short selling has received widespread attention and has been blamed for the collapse (or near collapse) of a number of financial institutions such as Lehmann Brothers, Northern Rock and HBOS. As a result, several countries opted to impose bans or restrictions on short selling.

Short selling is not a recent innovation and, as a matter of fact, the first reference to the practice of short selling stocks dates back to the seventeenth century. More precisely, in 1609, the Dutch East India Company made a formal protest to the Amsterdam Exchange, claiming that short sellers were able to make significant profits by short selling its stocks. Isaac La Maire, a Dutch merchant and a major shareholder of the company is considered to be the organiser of such short sale. Consequently, short selling was declared illegal because bearish investors were "incommensurably damaging innocent shareholders, among which are widows and orphans."

Way back in 1822, Jacob Little (known as the Great Bear of Wall Street), was the first person to short sell stocks in the United States, with the first restrictions in the New York Stock Exchange being implemented in 1917. Further regulations related to short selling were implemented in 1929 and 1940, after short sellers were being blamed for causing (or contributing to) the Wall Street Crash of 1929.

In 1949, Alfred Winslow Jones used short selling as a tool to hedge the market risk of (unregulated) funds, giving birth to Hedge Funds.

Three Californian brothers created a group (The Feshbach Brothers) focused on short selling in 1983. Their aim was to target companies involved in fraud and accounting anomalies or facing bankruptcy. A few years later, in 1985, James Chanos founded an investment company (Kynikos Associates) specialising in short selling.

As already discussed, short selling was once again in the limelight during the 2007-2011 global financial crisis, forcing regulators around the world to take measures aimed to stabilise stock prices.

Objectives of the Dissertation

This study aims to provide a comprehensive overview on the much debated market practice of short selling stocks. Analysing existing literature helps to identify the possible effects short selling can have on stock markets. Moreover, the study provides an understanding on how and why short selling transactions take place, together with who engages in short selling given the particular risks associated with such practice.

Another objective of this dissertation is to gauge the perception of Stockbrokers, various Hedge Funds and listed companies on the Malta Stock Exchange towards the practice of short selling on the local stock market.

Dissertation Structure

Chapter 2 analyses the arguments put forward by various researchers regarding the possible positive and negative effects of short selling.

Chapter 3 first explains how investors attempt to profit from short selling, that is, short selling at high prices and buying back at lower prices. Discussion will then focus on what differentiates Covered from Naked short selling, who is involved in a short sale transaction and the main motivations that may induce traders to engage in short selling. Finally, specific risks associated with short selling will be analysed.

Chapter 4 describes how the information needed to complete this study was obtained.

Chapter 5 begins with a brief overview of the recent developments within the Maltese Stock Market in relation to short selling. Discussion will then focus on the analysis of the questionnaire responses, providing an insight on how Maltese listed companies, Stockbrokers and Hedge Funds perceive the market practice of short selling and its regulation.

Chapter 6 concludes this study by providing a summary of the main findings together with suggestions for future research.

CHAPTER 2

LITERATURE REVIEW

Introduction

The market practice of short selling has been a debatable issue for years. Proponents of this practice argue that short selling can, amongst others, increase liquidity and promote information efficiency in stock markets. Opponents claim that short selling can destabilise markets and increase volatility. The aim of this chapter is to review the literature regarding the possible effects short selling of stocks could have on stock prices, listed companies and financial markets. Thus, the literature review is divided in two main sections. In Section 2.1, studies which highlight the positive effects of short selling will be reviewed. Section 2.2 features a review of literature focusing on the negative effects of short selling.

Positive effects of short selling

Studies on the possible positive effects of short selling date back to as early as 1977, when Miller (1977) developed the ‘Overpricing Hypothesis’ to model stock prices. An important consideration that has to be made is that, in most of the research under review in this section, the authors analyse stock markets where short selling is constrained [1] . Once the effects of short selling constraints would have been analysed, researchers attempted to determine the possible positive effects of short selling should short selling constraints be eliminated.

Miller (1977) developed a model (overpricing hypothesis) showing that those stocks which are not allowed to be sold short tend to become overpriced. This overvaluation is caused when, given their divergence of opinion, pessimistic investors are not allowed in the market (by short sale constraints), leaving optimistic investors to push stock prices upwards. Hence, Miller’s overvaluation theory relies on two key variables, that is, the presence of short sale constraints and the divergence of opinions among investors about a particular stock’s value. The theory may also suggest that short selling has a positive effect on the trading volume and on the turnover of the relevant stock. Moreover, liquidity is likely to decrease when certain investors (pessimistic investors) are not allowed to trade due to short selling constraints.

Diamond and Verrecchia (1987) use a rational expectations model with bid and ask prices to study the effects of constraints on short selling. The authors state that short selling constraints reduce the speed of stock price adjustment to private information. This might occur because short sale constraints do not allow informed traders to trade on their information. However, contrary to Miller’s overvaluation hypothesis, Diamond and Verrecchia do not conclude that short sale constraints induce higher stock prices.

A popular view endorsed by many market makers is that short selling increases market volatility and reduces stock prices. Woolridge and Dickinson (1994) use data from US markets to test the relationship between short selling and stock prices based on the following propositions; whether short selling effects stock prices and whether short sellers are able to earn abnormal returns. Results suggest that, through their activities, short sellers are not in a position to exercise downward pressure on stock prices. This implicitly leads to the rejection of the view that short sellers are able to earn abnormal returns to the detriment of less informed traders. Moreover, Woolridge and Dickinson conclude that, due to a positive relationship between short interest [2] changes and stock returns, short sellers provide liquidity in the market by shorting stocks when markets are rising whilst reducing short positions when markets are declining.

Charoenrook and Daouk (2005) examine the effects short selling restrictions have on volatility, liquidity and on the probability of market crashes. The study was conducted over 111 countries and in their survey letter, the researchers asked two important and distinct questions: whether and since when short selling was allowed in the stock market; and whether it was feasible for short selling to be practiced in such stock markets. The researchers provide a valid reason for asking the second question, in that, there may be instances where, due to lack of facilities, short selling cannot be practiced even though short selling would not be banned in that country.

The results of the survey are presented in Table I of the research paper, where there is also reference to the situation in Malta. According to the information gathered at the time research was conducted, short selling in Malta was neither legal nor feasible, although "legislation [was] currently being drafted to cater for securities lending".

After all situations were analysed, overall results showed an improvement in market quality when and where short selling is allowed. More specifically, Charoenrook and Daouk find evidence that when short selling is possible, there is less volatility in stock returns as well as increased liquidity. Moreover, findings suggests that short selling restrictions do not reduce the probability of a market crash.

Boehmer et al (2008) attempted to study which short sales were informed by analysing electronically submitted NYSE short sale orders from January 2000 to April 2004. They state that individual investors engage in short selling when they possess negative private information, while institutions are able to sell short after conducting expensive research. Moreover, they argue that even though corporate insiders with negative information about the industry are not allowed to short their company’s stocks, such negative information could be used to make a profit by shorting competitor’s stocks. Their study also observed short sale order sizes and found that very well informed investors use large orders (5000 or more) whilst less informed investors generally short less than 500 stocks. Finally, Boehmer concludes that short selling has a stabilising role in the market. This is because short sellers trade overpriced stocks and cover their position when all the negative information about that particular firm is included in the stock price (overpricing is dissipated), leading to more efficient stock prices.

In their report, Clifton and Snape (2008) examined the effect on liquidity on the London Stock Exchange following the Financial Services Authority’s decision to impose a short selling ban on selected financial and insurance stocks in September 2008. The analysis compared 15 banned stocks against 78 other stocks which were not subject to the short selling ban (control stocks) for the period 23 June 2008 to 30 October 2008. Clifton and Snape state that there are various measures of liquidity, including turnover, trading volume and the bid-ask spread. Some of the effects of the short selling ban were the following:

Wider bid-ask spreads for banned stocks compared to control stocks (a 150% greater increase)

Trading volume in banned stocks fell by 10% whilst trading volume in control stocks increased by 50%. Thus, liquidity shifted from banned stocks to those stocks that could be sold short even during the ban. This finding is therefore consistent with Miller’s (1977) suggestion that liquidity decreases when short selling constraints are imposed.

Turnover in banned stocks fell by 21% after the ban was lifted, compared to a 42% rise in turnover for control stocks.

Karpoff and Lou (2010) studied 454 firms that were found guilty of financial misrepresentation from 1998 to 2005. Their aim was to assess whether, through their activities, short sellers are able to identify firms which were misrepresenting their financial statements and whether short sellers have a positive or negative effect on other less informed investors. Karpoff and Lou conclude that firms found guilty of financial misrepresentation experience abnormal increases in short interest in the 19 months prior to the wrong doings being made public. They also found that there is a positive relation between the level of short interest and the severity of the financial misrepresentation. Thus, by using private information or by better understanding publicly available information, short sellers are able to detect financial misrepresentation and help speed up public disclosure of such misrepresentation. Moreover, uninformed investors will enjoy better market efficiency when short sellers reveal financial misconduct by corporate managers. In this way, uninformed investors avoid investing their funds in underperforming or fraudulent firms.

In view of the 2007-2009 financial crisis, Beber and Pagano (2011) compared the market performance of banned and non-banned stocks for the period January 2008 to June 2009. This study is in some way similar to that conducted by Clifton and Snape (2008). However, Beber and Pagano used a larger sample size (16000 stocks) and, unlike Clifton and Snape who only studied stocks listed on the London Stock Exchange, the stocks under investigation span over 30 countries. Beber and Pagano came to similar conclusions as in Clifton and Snape (2008) by stating that the ban imposed on short selling widened the bid-ask spread, decreased liquidity in general and slowed down price discovery.

Negative effects of Short Selling

The limited amount of literature available for review in this section is probably countered by the fact that this literature is of a more recent nature. In fact, amongst the literature under review, the recent financial crisis in the United Kingdom is used as a background to analyse the possible negative effects of short selling. Moreover, another literature analyses the market practice of short selling stocks from an ethical point of view, since ethical behaviour is becoming increasingly important in every aspect of business life.

Angel and McCabe (2009) argue that short selling has been a controversial issue not only in present times but also as early as the seventeenth century. However, few literature has addressed the issue of short selling from a business ethics perspective. Thus, in their article, Angel and McCabe provide a list of the usual ethical criticisms attributed to short selling, namely:

"Short selling creates an incentive for unethical activity"

Short sellers can spread false and misleading information about a company, which is considered as both illegal and unethical.

"Short sellers not only profit from the misery of others, they also cause it"

Shareholders can suffer losses when stock prices decline as a result of stocks being sold short. This is true when short sellers spread false and misleading information but can also protect potential investors from buying overvalued stocks.

"Short selling is just gambling"

A distinction has to be made between gambling and speculation. Gambling occurs when there is no probability of winning while speculation, although still risky, occurs when there is a probability of achieving a positive return.

"Short selling gives manipulators a tool to depress prices"

This reduces the efficiency of capital markets and creates problems for firms needing to raise additional capital.

"Short selling increases the volatility of markets"

Short sellers can worsen the fluctuations in stock prices when they react to negative news.

"Short selling permits the separation of voting from ownership"

Corporate raiders or hedge funds are able to influence a company’s election by buying votes of that company even though they do not have a legitimate economic stake in that company.

"Naked short selling permits manipulators to sell phantom share and unfairly depress prices"

Naked short selling occurs when the seller agrees to sell shares with the intention of not delivering then on the regular settlement date. Thus, a short seller may launch an attack on a company by selling short an infinite number of its shares until the share price is reduced to zero. Such share price may also hinder the company from raising additional capital.

"Naked short selling deprives legitimate owners of their voting rights"

When a vote is to be taken, large shareholders may be unable to exercise their voting rights if shares are not delivered on time. However, this argument may only hold with highly contested elections, which, according to the authors are not so common in these days.

In the end, the authors compare short selling with the invention of fire. Their aim is to make it a point that, albeit short selling may be used by unscrupulous investors for their own benefit, the practice of short selling is not in itself unethically incorrect and can be used, for example, to help markets work more efficiently.

Clifton and Michayluk (2010) discuss the impact of short selling restrictions on the London Stock Exchange during the financial crisis. During financial crisis, short sellers are regarded to short sell stocks without considering the company’s long-term future value. Thus, a prolonged period of short selling may have serious negative consequences on a financial firm’s capital and credit rating, which will in-turn result in more problems (creating a downward spiral). For this reason, during financial crisis, restrictions on short selling may stabilise prices by reducing speculation and excessive selling pressure, even though such restrictions may impair liquidity, leading to wider bid-ask spreads and more volatile prices. Thus, the Financial Services Authority’s (UK) decision in 2008 to prohibit the short selling of listed UK financial company’s stocks can be viewed as an attempt to restrict speculative short selling and to avoid market disorder and abuse. Moreover, new disclosure requirements were imposed, aimed to increase transparency and market confidence. When concluding, Clifton and Michayluk state that it is difficult to assess the desirability of short sale restrictions during periods of uncertainty, even if such measures appear to have restored some confidence in the market. The difficulty is based on that fact that one is not able to examine what would have happened in the market if such restrictions were not imposed.

In an impact assessment on the regulation of short sales, the EU Commission (2010) highlights a number of problems associated with short selling.

"Risk of negative price spirals"

Miller’s (1977) overpricing hypothesis is generally viewed to hold during ‘normal’ times. However, regulators are becoming increasingly concerned that short selling may create a ‘herding behaviour’ during financial crisis. This behaviour can lead stock prices to suffer excessive downward pressure and regulators to introduce bans on short selling financial stocks. Such provisions are aimed to reduce the ‘contagion effect’ whereby, due to a downward price spiral, financial institutions may suffer bank runs and effect other institutions.

"Risk of settlement failure associated with naked short selling"

Some regulators are aware of the risks that short sellers may fail to deliver shares on settlement date, even if such failures are very low in Europe and may not be intentional. In fact, settlement failures may be the result of back-office mistakes and delayed transfer of funds. However, recalling the Porsche-Volkswagen [3] case, regulators are concerned that at times, naked short selling may negatively affect share prices and destabilise the financial system.

"Transparency deficiencies"

Since the financial crisis, some regulators introduced disclosure requirements for short selling, as data on short positions was very limited before. This lack of data made it difficult for regulators to detect, monitor and sanction market abuses which could destabilise the market. Moreover, disclosure requirements can reduce the information asymmetry between informed short sellers and other less (or uninformed) market participants.

This report shows that regulators in EU member states are aware of possible negative effects of short selling and are implementing counteractive measures to reduce such problems. Moreover, through this working document, regulators are requesting the implementation of more harmonised regulations within the EU, aimed to reduce compliance costs, legal uncertainty and regulatory arbitrage.

McKenzie (2012) examines a number of reasons for which market regulators may resort to ban short selling. Such concerns relate to increased volatility, market instability, market abuse and settlement disruption.

"Short selling exacerbates price volatility"

Short sellers are known to increase their positions (sell more stock) when there is negative or bad news on a particular stock. Thus, by their actions, short sellers will cause stock prices to decrease even further, increasing volatility. The author states that this view was one of the reasons that led regulators to introduce short selling bans in 2008.

"Short selling destabilises the markets"

McKenzie quotes the SEC Chairperson, Mary Shapiro, who in 2010 stated that the SEC was worried that unrestricted short selling could "destabilise our markets and undermine investor confidence". However, in the absence of clear evidence that increased short selling negatively affects the market, this argument (which is supported by regulators and other critics) contradicts one of the findings of Boehmer et al (2008).

"Short selling leads to disorderly markets"

Given that short selling increases the speed of price adjustment to negative information, short selling may disorder the markets in ‘extreme circumstances’. In such situations, an instant price adjustment to negative information may be considered undesirable.

"Short selling facilitates market abuse"

There have been many instances in the beginning of the twentieth century where, acting as a group, some traders would short sell a stock and spread false rumours on that company, aiming to profit from the subsequent price reductions. This led regulators to introduce new trading rules such as the uptick rule (removed in 2007 and reintroduced in 2012), to prevent such practices. However, during the recent financial crisis, companies such as Bear Stearns alleged that they were victims of such practices. Consequently, this led the European Securities and Markets Authority to reintroduce bans on short selling in 2011.

"Short selling disrupts the settlement process"

Regulators are concerned that ‘naked’ short selling (i.e. when no delivery arrangements are made) may disrupt the market. However, McKenzie states that the option not to deliver is not to be associated only with short sellers since even market makers can choose not to deliver stocks when these are expensive or difficult to borrow.

CHAPTER 3

OVERVIEW OF

SHORT SELLING

Introduction

Chapter Three aims to provide an overview of the market practice of short selling stocks. Initially, a brief description of how the transaction unfolds is given together with an explanation of the main types of short selling (i.e. ‘covered’ or ‘naked’). For better understanding, covered short selling is further explained by a graphical representation and a numerical example. Subsequent discussion focuses on the main players in a short sale transaction, the motivations for engaging in short selling and on the risks associated with such market practice.

What is short selling?

Short selling is the market practice where, forecasting a decrease in a stock’s price, short sellers sell stocks they do not own at the current market price. Due to the fact that the stocks are not owned by the short seller, the short seller would be under an obligation to buy back the same amount of stock at a later date thereby covering the short position. During this process, the short seller would be hoping to buy back the stock at a lower price, with the profit being the difference between the stock’s sale and repurchase prices.

Short selling is only possible since stocks are fungible, implying that as long as stocks are of the same company, there can be no distinction between which stocks have been borrowed, sold and returned.

There are two main types of short selling; ‘Covered’ or ‘Naked’.

The European Commission defines ‘Covered’ short selling as a transaction where, prior to a short sale, the short seller "has borrowed the securities, or made arrangements to ensure they can be borrowed."

The other type of short selling, known as ‘Naked’ or ‘Uncovered’ does not involve the short seller "borrowing the securities at the time of the short sale or ensuring they can be borrowed."

A covered short sale transaction requires the short seller to borrow the stock (usually from a broker) so that they can be delivered to the buyer on trade date (T). Upon receiving the stocks and paying for them [4] , the buyer will not have any other involvement in the transaction. The short seller has to pass the cash proceeds from the short sale transaction to the broker, who will use these proceeds as collateral against the stocks borrowed by the short seller. The process described so far would still leave the short seller with an obligation to cover the short position at a later date. To cover the short position, the short seller would have to buy the same amount of stock in the open market and return them to the original stock lender, freeing up the cash collateral.

‘Covered’ short positions can remain open for an unlimited amount of time, provided margin requirements are continuously met and the original stock lender does not cancel the loan (or recall the stock).

Covered Short Sale.png

Figure .1 Covered Short Sale Transaction

Adopted from: A Primer About Short Selling (2009)

Figure 1.1 provides a graphical representation of a Cover Short Sale Transaction. Apart from the movement of stock and cash proceeds, a covered short sale generates a ‘Rebate Fee’. This rebate fee represents the difference between the interest paid by the short seller and the interest received by the borrower of the stock (short seller) on the collateral. The interest paid by the short seller, known as ‘lending fee’ varies according to the availability and demand for the stocks that have to be borrowed. The ‘rebate fee’ is generally received by the short seller as collateral interest normally exceeds lending fees. On the contrary, if lending fees are higher than collateral interest, the ‘negative rebate fee’ would be received by the stock lender.

Naked short selling is a more controversial issue than covered short selling, with opponents of this practice claiming that ‘naked’ short selling can be used as a tool for fraudulent activities. Those in favour of such practice argue that, when compared to covered short selling, minimal differences emerge and thus naked short selling can provide stock markets similar benefits as those provided by covered short selling.

Since ‘Naked’ short sales do not involve the borrowing of the stock that would be sold short, naked short selling can be used to avoid paying high borrowing costs. These high borrowing costs may reflect the difficulties involved in borrowing stocks where, for example, liquidity is insufficient (or low).

Naked short selling is generally used as an intra-day trading strategy, with the short seller opening and closing the short position in a single day. However, should the short seller be unable to close the short position on the same day, the short seller would be required to borrow the stock as in a ‘Covered’ short sale. As a result of ‘failing to deliver’ on settlement, in addition to lending fees, the short seller would also incur other fees.

Angel and McCabe (2009) clearly illustrate the view held by opponents of naked short selling. The possibility of not having to borrow stocks before a short sale is conducted may induce short sellers to sell an unlimited number of stocks (phantom shares), driving its price to practically zero. Angel and McCabe (2009) state that this form of manipulation (‘bear raid’) is probably "the greatest danger of naked short selling."

Reference has already been made to margin requirements. This is because short selling is a marginable transaction, where a short seller must have an open and active margin account with a broker. Regulation T in the United States requires that, for every short sale transaction, 50% of the short sale proceeds need to be deposited in the margin account to be used as collateral [5] . The broker will then be responsible to monitor the short seller’s position of a daily basis.

The following is a simplified example of a covered short sale transaction in the United States, where in its simplicity, the example does not take into consideration the costs incurred and any income generated from a short sale transaction:

The transaction, initiated by the short seller, involves the shorting of 200 shares at a price of $ 100 each. Therefore, the balance in the margin account at the beginning of the transaction would be $30000; where $20000 represents the proceeds from the short sale transaction and $10000 represent the 50% margin requirement of Regulation T.

The short seller would make a profit of $2000 if, during the following trading day, the stock price falls to $90:

$ 30000

Margin Account Balance

($ 18000)

Cost incurred to repurchase shorted stocks

$ 12000

Margin Account Balance after short position is closed

($ 10000)

Regulation T Additional Margin

$ 2000

Profit

On the other hand, the short seller would incur a loss of $2000, if, during the following trading day, the stock price increases to $110:

$ 30000

Margin Account Balance

($ 22000)

Cost incurred to repurchase shorted stocks

$ 8000

Margin Account Balance after short position is closed

($ 10000)

Regulation T Additional Margin

($ 2000)

Loss

In the later case, if losses exceed a pre-determined level, the short seller would be obliged to increase the amount of cash (or securities) in the margin account to meet margin requirements. Otherwise, the broker will be able to liquidate the position.

The players

As illustrated in Figure 1.1 and its subsequent explanation, apart from the ultimate stock buyer, a short sale transaction mainly involves three participating groups; stock lenders, short sellers (stock borrowers) and brokers (intermediaries).

D’Avolio (2002) states that in the US markets, custody banks such as Bank of New York [6] or State Street Bank act as the largest stock lenders. These banks act as an intermediary for mutual funds, pension funds and insurance companies who are considered to endorse "long duration, buy and hold investment" strategies.

Brokers act as an intermediary to facilitate the stock lending and borrowing process. In a short sale transaction, the broker would be approached by the short seller; with the latter requesting the broker to ‘locate’ the stocks to be short sold. As Duffie et al (2002) describe, the search for the stock can be conducted via an "electronic locate system" or through traditional communication system such as email, telephone or fax. Moreover, Duffie et al provide different approaches a broker can undertake to locate the stock.

The first approach is for the broker to locate stock from its own inventory or from its customers’ accounts. The next alternative approach would involve brokers contacting large institutional investors directly or through custodian banks. In this regard, Duffie et al state that brokers and institutional investors may even enter into exclusive contracts, enabling brokers to access and lend the institution’s portfolio of stocks [7] .

Although different factors could influence who acts as a short seller, the following are generally considered to be the main short sellers in every stock market.

Hedge funds

Even though not all hedge funds engage in short selling, hedge funds are considered to be the most active practitioners of short selling. These hedge funds normally use long/short strategies whereby short sales are used to partially cover long positions. This strategy allows hedge funds to ensure a continuous stream of returns, irrespective of any market conditions. Besides long/short strategies, hedge funds such as James Chanos’ Kynikos Associates are famous for specialising solely in short selling strategies.

Market makers

To execute customer orders when liquidity is insufficient (or low), market makers may engage in temporary short positions. For this reason, most of the recent regulations related to short selling do not apply to market makers.

Investment banks

Negative predictions about a particular company may induce Investment Banks to engage in short selling as part of their proprietary trading strategy.

Motivations for Short Selling

Diether et al (2009) state that speculation; hedging and arbitrage are the main motivations that may induce traders to engage in short selling. Moreover, market making and taxation may also feature as additional motivations for short selling.

Speculation

When traders consider particular stocks as overvalued, short selling provides a means to speculate/profit from the decline of such stock prices. Thus, speculative short selling requires constant monitoring for companies that may seem to be mismanaged or facing possible future problems. Chapter Two has already highlighted some ethical concerns related to speculative short selling, particularly the possibility of benefiting from the misfortune of others.

Hedging

Market players, example hedge funds, can reduce the risk emanating from the market (market risk) by simultaneously holding long and short positions in the same stock.

Index Arbitrage

When stock index futures contracts are considered to be cheap when compared to the underlying stock’s value, Index arbitrage can be achieved by shorting the stocks forming the index whilst buying the index’s futures contracts. As the futures approach expiration, price differences will narrow and a profit can be made irrespective of price movement’s direction.

Merger (Risk) Arbitrage

Semi-Strong market efficiency predicts that when a merger announcement is made public, the target company’s stock price would increase whilst the acquiring company’s stock price would decrease. Thus, traders seeking to profit from such price differences will buy (go long) stock of the target company and simultaneously short sell stock of the target company. One must however consider the inherent risks where, for several reasons, merger deals may not materialise or complications arise [8] .

Market Making

As already stated, market makers may resort to use short selling (even naked short selling) to meet customer orders. Thus, due to the relative urgency to complete transactions, market makers can be assumed to disregard whether stocks are overvalued or not (unlike speculative short selling). The UK’s Financial Services Authority (FSA) considers the activity of market makers as an important provider of liquidity in financial markets.

Taxation: Shorting against the box

Prior to the Taxpayer Relief Act (1997) in the United States, shorting against the box was a short selling strategy aimed to defer taxable gains.

"Delaying the recognition of a gain is particularly important if the investor will be taxed at a lower rate in the subsequent tax period." (Brent et al 1990, p.275)

This could be done by holding long and short positions in the same stock, with the short position not being covered. Contrary to a normal short sale, traders in shorting against the box transactions were not negatively exposed to the stock. However, the elimination of the tax benefits made this trading strategy more expensive with Arnold et al indicating that shorting against the box declined in popularity and use following the enactment of the Tax Relief Act of 1997.

Risks

As a market practice, short selling carries specific risks not associated with the more common and traditional form of trading, i.e. holding long positions.

Unlimited downside risk

Short sellers face the risk of unlimited losses as stock prices have no upper limit that can be reached. Brent et al (1990) suggest that risk averse and less experienced investors may find the unlimited loss potential undesirable and that buying put options may be a more valid alternative for such investors.

Recall risk

The stock lender reserves the right to recall the borrowed stocks at any time. Thus, the short seller faces the risk of not yielding any benefits from the short position. D’Avolio (2002) indicates that two choices are available for the short seller; either covering the short position or renegotiating the stock loan. The latter alternative is considered to be complicated and renegotiated terms may reduce short sale profits due to higher loan fees. The other option (buy-in or forced covering) entails buying the stock back and returning them to the lender, where losses can be made if the repurchase price is higher than the original short sale price.

Moreover, due to the inability to close out the position, short sellers may end up in a ‘short squeeze [9] â€™. For this reason, short selling is generally effected where there is sufficient liquidity, thereby reducing the risk of a short squeeze.

The Up-tick rule

Following the market decline in 1937, the Securities and Exchange Commission (SEC) introduced the ‘uptick rule’ for stocks listed on NYSE and NASDAQ. This rule practically allowed a stock to be sold short only if the latest price change of that stock was an upward movement. Thus, short selling would be prohibited if stock prices were going down.

The SEC removed the uptick rule in July 2007, on the basis that the restriction reduced liquidity and did not prevent manipulation.

Four months later, in November 2007, Citigroup was allegedly the victim of a ‘bear raid’. Misra et al (2012) claim that such market manipulation would not have occurred had the uptick rule remained in force.

As a result, widespread calls for the reintroduction of the uptick rule were made and in 2009, SEC started public consultations in a bid to reintroduce a variation of the uptick rule.

The modified uptick rule, adopted in February 2010, would act as a ‘circuit breaker’ to ban short selling in case a stock’s price falls by 10% in a single day. Misra et al define the new rule as "weaker" than the previous one and state that it would not have been of any use in the case of Citigroup, where prices only fell by 9% in a single day.

Conclusion

From the above analysis, it is clear that although short selling can be a profitable and useful investment strategy, one must also consider the risks associated with such market practice. In this regard, one may argue that James Chanos’ statement that "short selling has risks and costs because we are often swimming against the tide and may face unlimited losses if our analyses prove wrong" seems to suggest that, due to the precise market timing required, only skilled and experienced investors may succeed in short selling.

CHAPTER 4

RESEARCH METHODOLOGY

Introduction

The Literature Review in Chapter Two provides evidence that the literature available on the market practice of short selling stocks is quite vast. Thus, this explains the rationale behind basing most of the dissertation on secondary research sources.

Unfortunately, as at the time of writing this study, only one article discussed the issue of short selling within the Maltese Stock Market. This lack of literature is possibly due to the fact that, albeit short selling is legal and allowed in Malta, not a single short sale transaction has ever been conducted to date. Thus, the best way to get an insight on the local scenario with regards to short selling was through a questionnaire which will be the basis of the primary research for this study.

Secondary Information

Various sources such as journal articles, research papers, books and online materials were used to provide information regarding how a short selling transaction takes place; the use of short selling throughout the last few decades; who engages in short selling transactions; the different forms of short selling as well as the risks involved in such a practice.

Primary Information

To relate the market practice of short selling stocks to the local scenario, a questionnaire was circulated among companies listed on the Malta Stock Exchange, several stockbrokers and hedge funds. The aim was to gauge the respondent’s perception towards the practice of short selling on the local stock market.

The questionnaire was structured after establishing contacts with persons working within the Malta Financial Services Authority and the Malta Stock Exchange. These persons were asked to comment about the legality and feasibility of short selling in Malta and to provide clarifications regarding the recent implementation of the Legal Notice regulating short selling in Malta.

Further insight on the market practice of short selling both from a general and local perspective was achieved through an informal meeting with a hedge fund manager. The knowledge gathered will be included within the analysis of the questionnaire responses.

Questionnaire

For this study, questionnaires were an ideal method to gather information from respondents. This is because comparative analysis can easily be made when the questions asked are set in a standardised form. However, the major drawback of conducting questionnaires is the generally low response rate provided.

Considering that responding questionnaires may be time consuming and that respondents have busy working schedules, closed-ended questions were used throughout the questionnaire. However, the questionnaire was also designed to allow the respondents to provide further comments regarding particular questions. This would enable the researcher to gather more detailed information and reduce any restrictions imposed on the respondents due to the standardised nature of the questions and available answers provided.

Following the guidelines issued by the British Sociological Association, research participants were made aware that anonymity and confidentiality was being guaranteed and any information gathered will be solely used for the purpose of this study.

Structure of the questionnaire

The questionnaire is composed of four sections. The first section ‘Identification’ aims to provide basic information about the respondents. Section two ‘Introduction’ features a brief description of the rationale behind a short sale transaction. Section three ‘Short Selling in Malta’ hosts a number of questions related to the possible use of short selling in Malta, where amongst others, respondents were asked about the relevance of such market practice to the local stock market; the disclosure requirements imposed by the MFSA, and for what purposes would short selling be used on local stock market. The fourth and final section ‘Restricting or Banning Short Selling’ deals with the current issue where in some countries short selling has been banned or restricted, with respondents being asked whether this measure can help solve part of the problems companies were facing and whether the Maltese Regulator should also impose short selling restrictions or bans during times of financial turmoil.

CHAPTER 5

AN ANALYSIS OF THE

MARKET PRACTICE OF

SHORT SELLING

ON THE LOCAL STOCK MARKET

Introduction

This chapter will feature an analysis of the responses obtained through the questionnaire, which was circulated among listed companies on the Malta Stock Exchange, various stockbrokers and a number of hedge funds operating from Malta. A copy of the questionnaire is presented in Appendix I.

However, before the actual analysis of the responses, it is important to comment on the recent developments within the local scenario as regards to short selling. Thus, Section 5.1 will provide a brief overview of the situation in Malta prior to these developments as well as an understanding of what these developments actually were.

Short Selling in Malta

Reference has already been made to a study conducted by Charoenrook and Daouk in 2005, where the legality and feasibility of short selling in 111 countries were analysed. At that time, short selling in Malta was neither legal nor feasible, although it was stated that legislation to provide for securities lending was being drafted.

Moreover, research conducted by Russo and Rosati found that in Malta, "a securities pre-validation and blocking procedure [was] in place between the trading system and the securities registers held within the SSS.....making sure securities to be sold are available prior to trade execution." (Gregoriou, G. N., 2012, p.165)

The situation began to change in July 2012, when the Malta Stock Exchange (MSE) migrated to a new electronic trading platform, XETRA, which is operated by Deutsche BÓ§erse AG. Consistent with Russo and Rosati, the previous trading platform required that a pre-validation process takes place wherein it had to confirm that the stocks and funds were held by both counterparties to honour their trade. This pre-validation process was therefore obstructing the process of short selling. On the other hand, XETRA has no pre-validation process, paving the way for short selling.

Moreover, the Regulation on Short Selling and Credit Default Swaps adopted by the Council of the European Union in February 2012 came into force (locally) on the 1st of November 2012. The regulation was transposed into national law through the Financial Markets Act (Short Selling) Regulations, 2012 (Legal Notice 344 of 2012). The aim of this regulation was to provide a common regulatory framework within the European Economic Area with regards to restrictions on uncovered (naked) short selling and a number of disclosure requirements concerning significant short positions. The Malta Financial Services Authority (MFSA), which is the competent authority in Malta responsible for the implementation of the Short Selling Regulation, also issued a document to serve as Guidance Notes in this regard.

Interpretation of results

Respondents

In total, twenty (20) respondents replied to the questionnaire. Such a response rate is being considered ‘satisfactory’ due to the following reasons:

Chapter Four (Section 4.2.1) already highlighted the risk that questionnaires may incur a low response rate. In this regard, responses such as "it is not our company policy to complete these questionnaires" were expected and respected.

Given that the aim of the questionnaire was to gauge the respondents’ perception towards the practice of short selling on the local stock market, replies from potential respondent like "we have no knowledge of the Maltese Stock Market" and "we do not use short selling" were also expected.

Findings

This section will feature an analysis of the responses to each question within the questionnaire together with additional comments related to particular questions.

In the first question, respondents were asked whether short selling is legally allowed and/or practically feasible on the Maltese Stock Exchange.

Figure 5.1 Respondents consideration towards the legality and/or feasibility of short selling on the Maltese Stock Exchange

During the research phase for this study, an identical question was made to a representative within the Malta Stock Exchange. The response was that short selling on the Malta Stock Exchange was actually legally allowed, however it was not encouraged because of the risk of settlement failure. This risk emerges from the fact that the Maltese Stock Market is quite illiquid. In this regard, brokers would only engage in short selling if they know their clients well and if they are willing to incur the costs associated with the settlement of the trade (i.e. if settlement is delayed beyond T+3). Moreover, the MSE respondent stated that, unlike foreign countries, Malta does not have any market making and securities lending, both of which facilitate short selling.

The second question aims to assess the respondent’s opinion towards the relevance of short selling within the Maltese Stock Market.

Figure 5.2 Respondents reply as to whether short selling is relevant to the Maltese Stock Market

The relevance of short selling within the Maltese Stock Market was discussed in an informal meeting with a hedge fund manager. The following are the main effects short selling could have on the local stock market.

Positive effects

Considering that the local stock market is characterised by low trading volumes, short selling can potentially increase trading volume. This increase in trading volume can also help reduce the bid-ask spreads charged by local stock brokers since, given the current level of trading volume, brokers have to charge wide spreads to earn a profit.

Short selling may also improve the speed of price discovery on the local stock market. This would happen since short selling allows market players to trade on overpriced stocks, thereby reducing the possibility of stock prices being overpriced.

Negative effects

Controls should be in place so as to discourage market abuse which can involve the spreading of false and misleading information. Besides, naked short selling should not be allowed on the local stock market as this could be used to depress stock prices, leading shorted companies to experience negative repercussions on their capital base and credit rating.

At the time of writing this study, Cyprus was experiencing a major economic crisis, with Malta being touted to be next in line. In this regard, the interviewee stated that, at present, short selling could be devastating to Maltese listed companies since this could create a ‘herding behaviour’, leading to negative stock price spirals.

The official response given to the third question by a representative within the MFSA was that, in theory, all stocks listed on the Malta Stock Exchange can be sold short.

Figure 5.3 Respondents reply as to whether short selling should be allowed on all stocks listed on the MSE or on financial stocks only

Question four makes reference to the disclosure requirements imposed through the Short Selling Regulation. Whenever a person holding a net short position in relation to shares which are admitted to trading on a trading venue, such as the Malta Stock Exchange, that person is required to disclose details of that position to the public when the net short position reaches a value equal to 0.5% of the issues share capital of the company concerned and each 0.1% above that.

All notifications should be done via a readily available form on the MFSA’s website and according to sources within the MFSA, no such notifications have been received by the authority to date.

In this regard, respondents were asked whether short positions should be made public or whether these should be disclosed to and be kept confidential by the MFSA.

Figure 5.4 Respondents disclosure preferences

The majority of respondents preferred the option that short positions should be disclosed to and kept confidential by the MFSA. This contrasts with the MFSA’s obligation under the Short Selling Regulation. More specifically, the MFSA is requested to upload these disclosures on its website [10] and keep them public until such a short position exists. Once this position is closed, or reaches a threshold below the above-mentioned, the disclosure is moved to a historical section in the Authority’s website.

The following are some arguments generally put forward in favour and against public disclosure of short positions.

"Public disclosure will cause competitive harm"

The decision to short sale a stock is often taken by investment managers after conducting expensive and detailed studies. Thus, public disclosure could create ‘free-riding’ problems where some traders would be able to copy the positions of others for their own benefit and at the expense of the ‘original’ investment managers who experience a reduction in their gains.

"Public disclosure may confuse investors"

Apart from the general view that short selling is used to profit from the negative outlook on a particular company, Section 3.3 highlighted other motivations that may induce traders to engage in short selling. As an example, traders may engage in Index Arbitrage [11] to profit from arbitrage opportunities. Thus, public disclosure of short positions may lead investors in the shorted company to believe that the company has a negative outlook, when this would not be the case.

In a low liquid market such as the Maltese Stock Market, publication of short positions may be desirable for those participants who may want to engage in short selling. This information would enable these participants to gauge the risk of not being able to cover the short position when the need arises. Moreover, as Azzopardi and Camilleri state, the immediate publication of short positions may increase stock price efficiency even though higher transaction costs may be incurred.

The fifth question is related to the previous question (question four), where respondents were asked whether, given the small size of the Maltese Stock Market, they consider the threshold for public disclosure (0.5% of issued share capital of a company and each 0.1% above that) as set too high.

Figure 5.5 Respondents consideration as to whether public disclosure of short positions is set too high

In question six, respondents were asked whether they foresee the possibility for Maltese companies to become victims of illegal behaviour on part of short sellers.

This question was based on the knowledge that foreign companies were actually victims of such illegal behaviour. A particular case was that of HBOS, where false rumours on the financial stability of the bank led stock prices to fall by 7% in one day [12] . Such false rumours are deemed to have originated from hedge funds engaged in short selling, aiming to make a profit from the decline in the stock’s price.

Figure 5.6 Respondents consideration as to whether Maltese companies may become victims of illegal behaviour on part of short sellers

Responses to this question were almost evenly distributed with a slight majority of respondents seeing Maltese companies as possible victims of illegal behaviour on part of short sellers.

The Malta Financial Services Authority’s reputation of not tolerating any market abuse may have been a contributing factor towards the response given by the other respondents who declared that Maltese companies do not risk being victims of short seller’s illegal behaviour. However, this perception will need to be re-assessed once short selling gains popularity and use in the Maltese Stock Market.

The majority of respondents replied negatively when asked (in question seven) whether they envisage that the institution they represent may engage in short selling other company’s stock.

Figure 5.7 Respondents reply as to whether they envisage the use of short selling by their representative companies

Nevertheless, more than half of the respondents (58%) to question eight stated that Hedging would be the main motivation for which their company would engage in short selling. Some of the respondents who chose ‘Other’ were not in a position to state what would motivate their company to engage in short selling.

Figure 5.8 Motivations behind engaging in short selling

Since short selling is an investment strategy, question nine required respondents to state how short selling would be considered by their representing company.

Figure 5.9 Short selling as an investment strategy

Question ten relates the market practice of short selling to the recent financial crisis, where during this period several European countries imposed bans or restrictions on short selling. Market regulators resorted to such measures to counter "exceptional market conditions" and "extreme volatility". However, various critics stated that short selling bans were not only ineffective but may have also reduced liquidity, increased spreads and resulted in higher transaction costs.

In this regard, question ten seeks to identify whether respondents retain that such measures were helpful in resolving some of the problems companies in these countries have been facing. The majority of respondents seem to agree with the arguments put forward by various critics that short selling bans or restriction were ineffective.

Figure 5.10 Respondents view regarding the effectiveness of short selling bans or restrictions

The last question, question eleven, is linked to the previous question (question ten), where this time respondents were asked to state whether they agree that the Maltese regulator should also impose short selling restrictions or bans during times of financial turmoil. Interestingly enough, even though the majority of respondents viewed such measures as ineffective, more than 75% of respondents agreed that restrictions or bans on short selling should be imposed by the Maltese regulator in times of financial turmoil.

Figure 5.11 Respondents view as to the imposition of short selling bans or restrictions by Maltese regulators in times of financial turmoil

Conclusion

This chapter presented an analysis of the questionnaire which aimed to gauge the respondent’s percept