What is short-selling?

19 September 2008

The Financial Services Authority (FSA) has temporarily banned the practice of short-selling in a bid to improve market stability and bolster consumer confidence in banks.

The ban, which will last until the middle of January 2009, threatens the activities of thousands of UK-based hedge funds and traders. The City watchdog has become increasingly concerned that such firms have used current market turmoil to cash in, at the expense of consumer confidence in the banking system.

Short-selling is the practice of betting on a stock falling. It works likes this: speculators borrow shares and quickly sell them on, in the hope that the price will fall before they have to buy them back again. The trader then pays a cut to the shares' original owner, and pockets the rest of the profit.

Although not illegal, short-selling has been blamed for sending banks’ share prices plummeting and destabilising the global financial system. HBOS is a classic example, with its share price nearly wiped out prior to the takeover bid from Lloyds TSB.

The Liberal Democrat's deputy leader, Vince Cable, warned at his Party's conference in Bournemouth earlier this week that the practice of short-selling was putting the UK taxpayer at risk.

“Hedge funds [have] engaged in what is called short-selling and driving a bank, in this case HBOS, to the edge of collapse in order to make speculative gains with the knowledge that the government is standing behind the banks, so they are in fact gambling against the taxpayer, and that has to be stopped.”

Last night, the FSA stepped in and announced that, from midnight, the practice would be banned. Its chief executive, Hector Sants, says short-selling is a legitimate practice but has led to "disorderly markets".

"We have taken this decisive action, after careful consideration, to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector,” he said.

Shortly after the announcement was made, Callum McCarthy, chairman of the FSA, said at the Lord Mayor's City Banquet, that the UK's current trading system allows financial firm to be "targeted" by "extreme short-selling pressures".

As a result, a banks' falling stock price can cause alarm among customers, and poses the risk of another run on the bank as seen with Northern Rock in 2007.

Chancellor Alistair Darling has welcomed the move. “I believe it is the right thing to do in the current market conditions and in the interests of financial stability,” he says.

With short-selling banned, the hope now is that share prices - especially banks' - will calm down, and we will see an end to sharply falling stock.

Not everyone, however, has welcomed the move.

The Investment Management Association admits that the move will help consumer confidence, but it maintains that short-selling is not the principal reason behind falling bank shares.

And others are even less enthusiastic.

Simon Denham, managing director of Capital Spreads, questions why the Bank of England has pumped so much money into the banking sector if it is so confident that firms are safe.

"Obviously the authorities are not as sure as their public utterances would seem to suggest," he says. "The knee jerk reaction of politicians to find a scapegoat (short-sellers) and to try to stamp on it is just mind-blowingly stupid."

Denham argues that a similar ban a few months ago on short-selling in the US did not have much impact.

Read the latest Moneywise blog: "Are they reaping what they sowed?" 

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