Introduction to Short Selling

Introduction to Short Selling

Introduction to Short Selling 1401 788 Hauzen

Short selling refers to the sale of securities the seller does not own. You ‘short’ a security by selling the security in the hope that the price will decline and you can buy it back in the future at a lower price. If a seller borrows the security to short it, the transaction is a covered short. If the seller simply sells the security without borrowing it first, then the transaction is a naked short. While normally an investor bets on the price of a stock going up in the future (the practice of ‘going long’), shorting a security enables an investor to hedge their financial position in a bearish market by betting on the fall of a particular security. In Hong Kong, only certain specified stocks can be sold short.

Basic features

When shorting a stock, the shares are borrowed from a third party—normally, a broker. The broker, who holds the securities for another investor that owns the securities, asks for collateral exceeding the value of the stock which is borrowed.

As at September 2020, there were 876 securities that could be short sold under Stock Exchange of Hong Kong (SEHK) rules, with these stocks known as Designated Securities.

In Hong Kong, short selling must be ‘covered’ which means that when selling the stock, the investor must have borrowed the shares or have approval from the lender that the stock is available to loan to the investor. ‘Naked short selling’ is prohibited Hong Kong. It refers to a transaction where a stock is sold short without borrowing or buying the relevant securities to make delivery.

In addition, short sales must be executed at or above the best current asking price (the ‘tick rule’) on the SEHK’s trading system. In this respect, Hong Kong has a more stringent approach in its regulation of is trading technique than in other jurisdictions.

Risk of market abuse

Short selling is controversial because it is prone to a number of risks. For example, when a large number of investors decide to short a particular stock, their collective presence in a market may attract misleading attention and impact on a company’s share price. Rumours may also be planted in the market to portray the stock as under attack and cause sharp declines in company stock. Risks of abusive practices have led to outrightshort selling bans by regulators in many jurisdictionson several occasions.

Financial crises and short selling

Practice has shown that governments are inclined to ban short selling in the face of financial adversity as an attempt to stem sharp declines in share prices. Most notably, the Global Financial Crisis of 2007-2009 was marked by short selling restrictions. In September 2008, the Securities and Exchange Commission (SEC) and the Financial Services Authority (FSA) announced a temporary ban on short selling amid the Lehman Brothers crisis. At the time, SEC Chairman Christopher Cox commented: ‘[We are] committed to using every weapon in our arsenal to combat market manipulation that threatens investors and capital markets. The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets.’ He also stated that the action ‘would not be necessary in a well-functioning market’ but ‘is temporary in nature as part of the comprehensive set of steps being taken by the Federal Reserve, the Treasury, and Congress.’

In normal market conditions, short selling helps price efficiency and boosts liquidity in markets. However, during a period marked by sudden price drops, short selling can exacerbate the ‘crisis of confidence.’

In Hong Kong, short-selling regulations were enhanced following the Asian financial crisis of 1998 in which the government intervened in the stock market to counter aggressive short selling activity. Amidst a slump in the market on 14 August 1998, the Hong Kong Monetary Authority (HKMA) began to acquire Hong Kong stocks and pumped HK$120 billion into the market by the end of that month. The move drew criticism in light of Hong Kong’s free market economy.

At the time, there was no legislative requirement on reporting and disclosure of short selling. However, listed companies were bound to report short selling orders. Failure to do so would result in disciplinary action by SEHK. Policy-makers amended legislation to make such disclosure of short selling a statutory requirement, and extended the reporting requirements beyond listed companies to include sellers of shares and other market participants. Moreover, penalties against ‘naked’ short selling were increased.

As a result, only covered short selling for certain designated securities prescribed by SEHK is now permitted, with short sales only to be executed on the SEHK’s trading system at or above the best current asking price (the tick rule). A full audit trail is required to be kept for covered short sales: for example, when clients place short selling orders, they must provide documentary confirmation to their brokers or agents that the sale is shorted and it is covered. A breach of these requirements can result in criminal prosecution.


ORIGINALLY PUBLISHED ON LEXISNEXIS

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