ASX Short Selling Ban - What does it mean for you?

If you have been reading the Australian and International papers recently, you will have heard that both the US and UK markets have placed a ‘temporary’ ban on short selling in an attempt to reduce the overall volatility in the markets. Short Selling, by its inherent nature, relies on volatility as the primary element to spin a profit from a stocks negative movement. ASIC published this press release yesterday which outlines the details of the ban. I’ve had a few emails from people wondering what it all means, and it this ban going to shut down the derivatives market - the most commonly used pre-market indicator for the Australian Stock Exchange. The ‘temporary’ ban introduced will ban all short selling - naked and covered for 30 days on the ASX.

So what does the ban mean?

Well firstly, we have to clarify the difference between naked short selling and covered short selling. Typical short selling is referred to as covered short selling - the practice whereby a trader sells a security that they do not own with the expectation that the value of the securities will decrease allowing them to sell the securities at current market prices and then buy the securities back when they fall in value. With enough value drop, the trader can purchase the securities and ‘cover’ their position for less than they received for selling them earlier. Of course, if the price increases then the trader is required to cover the increase and they lose money. The difference between a ‘covered’ short selling and a naked one is that a naked short sell is selling a stock without borrowing the shares. This creates a position when the seller does not obtain the shares within a specified time period and subsequently fails to deliver on their obligation. This type of short selling typically incites more negative sentiment in a stock.

So basically, ASIC has banned the practice of engaging in short selling for the next 30 days from today by completely banning naked short selling and covered short selling until global markets stabilize.

So what does this mean for the market?

Well, firstly there is no question that it’s going to stabilize the market simply because short selling has always had the compounding effect of spiralling negative market news on a stock out of control. While this is true, I find it a bit rich that the ASX has not placed a ban or restricted the trading of options and warrants in the market since the creation of adverse option positions can have the same effect (although perhaps not as drastically as short selling.)

Overall, I think the decision was the right one and one that ASIC should be applauded for (although *cough cough* they didn’t really have much choice). Evidently, the new restrictions are going to stir up the whole ’stock lending’ debate and whether hedge funds and large institutional investors should be allowed to profit from the falling prices of shares by engaging in the practice of short selling and charging fees for lending out their clients shares. They argue of course, that the profits are shared with the client and can assist in reducing their management fee’s.

My take on this is that short selling is useful since it help liquidity in the market - but is difficult to regulate and can often result in market manipulation. Think of this way, a big institutional lender places a short sell position on a company which may signify to the market that it knows something about the company that others do not - so the rest of the market starts short selling on the company and the companies stock is shot and in financial freefall. Of course, the company may be perfectly profitable and solvent and have no pending issues - the mere ‘fabrication’ of negative sentiment in a market like the current one will cause a frenzy from investors who are waiting for the next big (or small) company to fall.

So ASIC’s decision makes sense for now - it will be interesting to see what restrictions they enforce once the market stabilises and the 30 days ‘temporary period’ is up.