Hedge funds and short sales. An open debate

Rafae Hurtado. Professor. IE Business School

7 September 2009

The collapse of the stock market has highlighted the shortcomings of the hedge fund system of short sales and fuelled debate on the need to set limits and rules for this type of operation.

In recent months, and in particular after the great crash of the stock markets as from September 2008, the hedge fund system of short sales has been a subject of analysis and debate by many players on financial markets. The consequences and system of short sales are a source of great controversy in the financial sector.

Short sales take place through the loan of securities. A short position (short sale) takes place through the sale of an asset that is not held by the investor, but borrowed through an intermediary and later bought to pay the loan. The profit is obtained if the initial sale is completed at a higher price than the purchase price. With a short sale, the investor obtains greater profit if the price of the asset falls.

On many occasions, hedge funds not only involve short sales, but also use a significant amount of leverage.

For a short sale, an intermediary must lend a certain number of shares. Some companies say that they have uncovered signs of their shares being lent as part of a chain. This type of transaction involves further risk.

In practice, the financial intermediaries that lend shares so that hedge funds can make short sales are the banks with which the said shares have been deposited. On many occasions, the shareholders (and owners of the shares that are lent) have declared that they are unaware of any clause in their deposit contracts whereby their shares can be lent and whereby the bank that acts as a depository is authorised to receive the profitability paid by hedge funds for the risk assumed by lending shares.

However, the greatest controversy in short sales is their potential effect on prices. In recent months, we have seen how the instability of financial markets can have very negative consequences not only for investors, but also for the economy as a whole.

There are many financial players who consider that, in certain sectors and on certain markets, short sales may have had a very significant effect. The most important case is perhaps the financial sector of the United Kingdom, where the sudden fall of prices has done away with certain increases in capital of the banks and contributed to the intervention or mandatory takeover of certain institutions.

Spain has also been affected by events on other markets. The catastrophic vision certain investment banks have of the Spanish real-estate sector, together with the low-level stock market capitalisation of banks from other countries (especially the United Kingdom, Benelux and Germany) have led to Spanish banks in general and the so-called domestic banks in particular to be the object of short sales.

The fall of the stock market prices of banks is capable of causing not only a perverse spiral (the further the share price falls, the more certain investors feel obliged to sell as a result of their risk management policies, which worsens the situation even further), but also of generating a loss of trust in deposit entities by the uninformed general public.

In view of this situation, which is the result of short sales, measures must be taken. The most commonly proposed initiatives include transparency and the temporary prohibition of short sales. Hedge funds in particular, as well as other institutional investors, must provide detailed information about their short sales. In addition, certain deposit entities that lend securities should provide detailed information about their transactions. It is evident that communication duties for short sales are unquestionably open to improvement.

In Europe, the French idea of introducing greater capital requirements of banks that finance hedge funds owing to the greater risks they run, as well as requiring greater transparency of the funds themselves, has sparked great interest. The French finance minister, Christine Lagarde, has also proposed that not only hedge fund managers should be registered with the European Union to operate on the region´s stock markets, but also the hedge funds themselves should be submitted to a register that requires the fulfilment of strict rules on transparency.

Besides transparency and capital requirements, we must remember that the promotion and development of MIFID and Market Abuse directives to include the changes that are necessary for fostering transparency and the free formation of prices on the market could be an excellent way of giving financial markets the required stability.

The legislation of hedge funds is not the only requirement; it is also necessary to legislate their activity and results on the stock markets. Issues such as price manipulation and market abuse must be prosecuted by the appropriate legislation, regardless of the investor or investment vehicle.

The short-sale strategy is used by a high percentage of hedge funds and, as a result of their characteristics and possible consequences, the levels of transparency and control need to be drastically increased. The legislator, the shareholders whose shares are lent, listed companies and investors in general have the right to due transparency in this area.

Despite the fact that hedge funds can have very positive effects on financial markets, such as the reduction of inefficiency levels or the increase in liquidity, in the case of short sales and, in particular, short sales on shares in the financial sector, the legislator must be especially careful, since financial stability depends heavily on it.

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