Former Fed Chairman Allan Greenspan criticised SEC's ban on short selling and identified short selling as a 'terrible idea' since it had a very important role in setting market prices. The Securities and Exchange Commission has banned short sale of about 950 financial-related stocks until October 2, 2008, a list that ranges from Goldman Sachs Group Inc to International Business Machines Corp, which was added last Wednesday. What does short selling mean? Short selling means (to inform readers who are not familiar with this term) selling a security, contract or commodity not owned by the seller. However, the seller is committed to eventually purchasing the financial instrument previously sold. Wall Street Journal, however, condemned ban on short selling and says that it is like taking the 'hedge' out of hedge funds.
Regulators are clearly panicky and end up by targeting short sellers as a way to prop up share prices, which ultimately terrifies in turn financial professionals and individual investors who see regulators losing faith in the system they oversee. A UBS research note spoke for the widespread disbelief that modern regulators could ban short selling, even temporarily, even as a form of circuit breaker. "This can be characterised as a populist reaction of no positive value." the report said. "Anyone who seriously thinks that the cause of this crisis arises from the actions of evil and manipulative speculators lacks the insight and knowledge to be allowed anywhere near the regulation of financial markets."
Market-neutral funds offset the risk of random market swings that they take when buying stocks by short selling, or selling borrowed stock, in an equivalent dollar amount of other shares. That way, as long as they choose their stocks well, they will make money whether the market goes up or down. The ban leaves several unintended consequences. It challenges risk-lowering hedging strategies and also raises the costs of trading by widening the bid-ask spread, add to volatility, and make prices less accurate. Academic studies found that the three-week ban on short selling did not stop banking shares drop on a continual basis.
It is obvious short sellers are not especially compassionate characters. Bottom line is that these short sellers are benefited from the decline in value of other people's investments. But in complex markets, short sellers are similar to investigative journalists, looking for the opportunity of finding an overrated company or industry, which is under the false impression of financial health. That represents an effective alert to avoid holding or increasing their positions in failing companies. It has been said that short sellers actually prevent crashes because they provide a voice of reason during raging bull markets. However, like journalists, short sellers are not always popular with corporate management or regulators. Forensic accounting experts at hedge funds have performed the hat trick of being the first to signal, through short selling, troubles at Tyco, Enron and now Fannie Mae, Freddie Mac and banks.
What is the scenario now for Dhaka Stock Exchange (DSE) in Bangladesh? After dividends are paid, stocks face a free fall in DSE. For instance, if you look at a one-year price graph of any bank on the DSE website, you will find out the truth. In theory, after dividend, price drop equals to the amount of the dividend. But at DSE, price falls about 50 per cent after dividend. It happens not only this particular year; this phenomenon is an ongoing feature of DSE for the last eight years. If short selling were allowed, and all the investors are aware of the mentioned phenomenon, they would take the opportunity by selling short those stocks which would eventually eliminate 'after dividend free fall price drop' from the market. In that way DSE will be able to establish more accurate price in the market.
Day netting is another form of short sale that was allowed earlier in the stock market but withdrawn before the introduction of automated trading. However, at last the Securities and Exchange Commission (SEC), the stock market's watchdog in Bangladesh, approved the DSE Short Sale Regulations 2006. But like other government laws to provide good governance, DSE short sale regulation did not face the light.
As a matter of fact, an informed seller also needs to let off vapour just like an informed buyer must be allowed to take a position proactively. Such a level-playing field prevents the market from staying on a bullish course for an unrealistically long period of time ecstatically, if ignorantly, unaware of the infusing trouble. When something is suppressed for long, the outcome is catastrophic when the lids are lifted, which is why allowing of level-playing field to both bulls and bears is of paramount importance. However, since DSE is a frontier market and manipulation frequently takes place in DSE, short sale has to be allowed after ensuring strict vigilance to get full benefit from the option.
*Me & Salahuddin Ahmed from Ashland University also contributed in this article. The article was published on the daily Independent (Editorial, page 6) in Bangladesh on November 13, 2008.
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