It was expected that financial stocks  would rally on the first day of the  short-selling ban in Australia, back on  September 21. The ASX200 financials  index (XFJ) gained 5 per cent that day,  as shares in ANZ increased by 8.1 per  cent, Commonwealth Bank of Australia  by 4.4 per cent, Westpac by 4.9 per cent  and NAB by 5.65 per cent.

But as the market continued its  decline, with much volatility, in the
following  days, Rick Steele, chief
executive  of market neutral hedge fund
TechInvest,  questioned whether the ban
was a  “one-day wonder”.  The ban, imposed by the Australian  Securities and Investments Commission  (ASIC), was intended to shield the  Australian sharemarket from shortsellers  worldwide who found themselves  deflected from other exchanges by  similar regulatory interventions.

Tony  D’Aloisio, chairman of the regulatory  body, also pitched the ban as a “circuitbreaker”  that could restore confidence.  But the shorting bans imposed by  western and Asian market regulators  were never going to stabilise markets  destabilised by powerful macroeconomic  forces, Steele said. An absence of  short-sellers would not encourage flows  of credit, halt deleveraging and resultant  forced-selling into falling markets, or  prevent redemptions. 

Don Hamson, managing director  of Plato Investment Management,  said short-selling was not the cause  of declines in the share prices of  financial companies that were seen as  under siege: rather, the prices of these  companies fell because they were
“overleveraged  and poorly-managed”.  D’Aloisio shared this view: some  downward price movements “reflected  the market being hard on companies  with high asset values and high gearing,”  he said.

While ASIC judged that shortselling  was not creating a disorderly  market, its primary focus was the disclosure  of covered short-selling.  On November 19, when ASIC  began allowing covered short-sales of  non-financial stocks, the ASX 200 had  fallen by -29.82 per cent, while the XFJ  had sunk by -30.7 per cent, since the  inception of the ban on September 21.  While the powerful macro forces make  it difficult to determine the precise  effects of the ban, some managers have  run analyses of its impacts on share  prices, trading volumes and volatility. 

Without short-selling, pricing  inefficiencies distorted the true value of  securities, according to Tribeca Investment  Partners. As buy-sell spreads of  securities widened and trading volumes  thinned out, liquidity contracted.  An increase in market volatility  was observed, too. Tribeca found the  range between the highest and lowest  daily trading prices of the median  stock doubled after the ban took effect.  However volatility spiked globally during  this time: measurements recorded  by the Volatility Index, which gauges  market expectations of near-term  volatility conveyed by S&P500 stock  options, ranged from 36.92 on September  29 as high as 89.53 on October 24,  as markets shed capital. 

Plato found the liquidity of the  ASX300 was reduced and intra-day  volatility increased after the ban was put  in place. 
The average level of trades for each 
stock fell by 13.7 per cent, or 279 trades  each day, in the 15 days after the ban  was introduced, according to Plato. A  broader analysis, which covered daily  trading data from January 2 to October  13, found the total volume of shares  traded fell by approximately 194 million  shares traded daily after the ban took  effect. 
An observation of trading activity 
on the October 6 Labour Day public 
holiday in NSW provided Plato with 
a benchmark for low trading volumes. 

Plato concluded that, as a rough  estimate,
liquidity contracted during  the ban to a
level roughly half of that  measured on
the public holiday, reducing  liquidity,
slowing the transmission  of negative
news to the market and  increasing the
costs of trading.  The analysis also
identified an  increase in the
volatilities of stocks.  Absolute
intra-day volatility, a measure  of the
ratio of the highest and lowest  transaction
prices of a stock on a given  day, rose
from 5.4 to 7.7 per cent, while  idiosyncratic
or ‘index-relative’ volatility,  which
subtracts the absolute volatility  of the
index from the same measure of  a given
stock, increased from 3.3 to 4.3  per
cent. 

In its defence of the ban, ASIC  argued that the lack of transparency of  short-sales weakened investor confidence,  increased the cost of capital and  reduced trading. But the absence of  shorting has brought the same consequences,  Steele said. 
He said the shorting bans in other 
developed markets presented Australia  with a “remarkable” opportunity  to stand up for the principle of free  markets.

Since short-selling provides  companies with a deeper and more  liquid market in their securities, lowers  the cost of trading for investors and
improves  price discovery, Steele
reasoned  that investors prefer to trade
in freer  markets and that companies
would  want to raise capital there. By
following  the moves of regulators in New York,  London and Tokyo,
Australia
failed to  “take leadership”.  But D’Aloisio said recent events had  vindicated the regulator.  “Were we correct? We believe we  were…Our approach has not been  without controversy: unannounced,  sharp changes in the law are not good  for markets.” 

He said the Italian market regulator’s 
ban on naked shorting, imposed  when
Australia
had banned all shorting  trades, resulted
in heavy selling of one  of the country’s
largest banks, which  later caused a ban
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 sales, then all shorts.  “We believe we avoided  similar disruption on our market  by placing the ban on when  we did,” D’Aloisio concluded.  The new shorti ng  rules  Alternatives
managers say  the new reporting
requirements  of short sales should  follow global practice, in which  investors, or their custodian or  prime brokers, report shorting  interest, to the regulator or the  exchange. 

Short interest is measured  by the
total number of shares  in a company that
have been  sold short, and is reported as  a percentage of outstanding  shares in a company.  ASIC now requires  short-sellers and the brokers  they trade through to report  shorting transactions on a daily  basis, so the ASX can release a  report that shows these trades,  in aggregate, one hour before  trading starts on each working  day. Unsettled trades are not  reported. 

Kim Ivey, chair of the Australian 
chapter of the Alternative  Investment
Management  Association, said capturing  daily trade data would not  provide the amount of short  interest in a listed company,  or the rate at which that short  interest is changing.  He said that reporting daily  trade data would “significantly  distort” the actual shorting  activity of a stock because it  failed to show the size of the  position and its implied impact  on the price of the stock.  ASIC’s focus on daily  information is understandable,  but fortnightly reporting of the  short interest in a stock, which  is practiced in the US, would  serve the market well, Steele  said. 

He
said there is rarely any  significant
change in the short  interest of a stock
from one  fortnight to the next.  When publicised, short interest  positions can inform the  investment and risk management  decisions made by managers.  For example, securities  with a lot of short interest are  susceptible to a short squeeze  if new, positive information  about that security hits the  market.

But using the ASX  short-selling reports to arrive at  short interest positions would  be a big, impractical exercise,  Steele said. 
It would be more efficient  if
custodians (rather than brokers)  supplied
managers’ short  positions to the
exchange since  they capture, settle and report  this data each day on a tradedand-  settled basis, Steele said.  Offshore managers investing in  the Australian market use subcustodians  that could provide  this information.  Also, custodians would be  more suitable to provide this  information since brokers do  not always carry a record of  holdings for clients, and investors  sometimes use a number  of brokers to conduct trades,  Steele added. 

ASIC believes a staged  lifting of
the ban is appropriate  due to the
volatility in  the market. As Investment
&  Technology went to press, its  position was that the ban on  short-selling financial stocks  would remain at least until  January 27, 2009.