The Great Short-Selling Swindle Explained

The recent decisions by major market regulators to reduce market volatility by restricting short-selling have generated much controversy.

Most media coverage has sought to educate the public as to what short-selling is and debate whether the growth of the practice is a cause or merely a symptom of the financial crisis gripping the world. Questions have also been raised as to whether it should be permitted or not.

Despite this, I have not seen anybody attempt to explain how short-selling has been abused in the last year to lead us to the situation we have today.

This article aims to uncover how short-selling has been abused as a tool of market manipulation and deception on the Australian Markets (the ASX). Before continuing, it is essential that you understand the following terms: short-selling, hedge fund, short-position, long-position, margin calls and stop-loss order.

The Swindle in a Nutshell

Hedge funds and other large short-term speculators have been short-selling stocks in vulnerable companies without disclosure, using stock borrowed from investment funds with large portfolios, with the intention of triggering margin calls and stop-loss orders to further propel the fall and cause a collapse in market confidence, allowing them to buy back stocks at bargain basement prices and make massive profits at everyone else’s expense.

Short-Selling in Australia

Prior to the last Sunday, short-selling could be carried out in two ways:

  • Naked shorting – placing a sell order, without having any shares to deliver
  • Covered shorting – selling shares that have been borrowed from another party, to be returned at a later date

Naked shorting was the most restricted – it was only permitted in specific leading large-cap stocks, and the number of short positions was supposed to be limited to 10% of the shares on issue in the stock. Brokers were always supposed to report their clients’ naked short positions to the ASX, and prevent them from opening prohibited ones.

In practice, if a naked position was opened and closed on the same day, these restrictions would be almost  impossible to enforce. Even when naked short positions were properly reported, the only people who would know would be other brokers who receive the complete market depth information from the ASX, unlike most retail investors who receive only a limited subset.

In contrast, covered short-selling using borrowed stock went largely unreported. To the rest of the market, a covered short is indistinguishable from a regular sell order, as the stock is ultimately delivered to the buyer at settlement. The only parties who know the true origin of those shares are the stock broker that initiated the sale, and the party who lent the shares.

The Origin of Borrowed Shares

One can borrow shares from anyone prepared to lend them.

Hedge funds usually borrow stock from investment funds with large long-term holdings. The biggest stock lenders are superannuation (retirement) funds, who receive fees in exchange for this service. It has been reported that for some fund managers, 30% of all their holdings are being lent out at any point in time.

One could say that that fund managers are allowing their investors’ assets to be used as a weapon against them. Most people who have their superannuation invested in shares are completely unaware that their holdings are being lent out in this manner.

The Avalanche Effect

If someone sells enough shares in a given stock in a sufficiently large quantity, it will overwhelm the bidders and force the market price down. As the share price falls, there is an increasing probability that margin calls and stop-loss orders will be triggered, further adding to selling pressure, creating an avalanche-like effect, causing the share price to fall even further.

The only way to counter a false oversupply caused by undiclosed shorting is for someone to know, or suspect that something fishy is going on, and fight back by buying. In this currently depressed market, not many people would have the stomach for that action. Most participants would interpret a sudden increase in selling as a precursor to the announcement of bad news to the market.

Vulnerable Shares

To maximise the likelihood of success, the hedge fund must choose a share that is vulnerable to this kind of manipulation. The best candidates are:

  • Mid to large cap shares in companies that are commonly held as long-term investments
  • Shares with good liquidity – a large daily volume traded, to ensure that the hedge fund can enter and exit their position quickly.
  • Shares in companies who have rivals that have announced bad news, which could be perceived to affect their sector as a whole. For example, the Investment Bank Babcock and Brown’s (BNB) recent troubles that may have provoked rumours and speculation about their rival Macquarie Bank (MQG) whose shares experienced wild volatility recently.
  • Those companies who are experiencing difficulties or are in negotiations with creditors or buyers, e.g. ABC Learning.
  • Shares in companies that margin lenders lend against and are are available for trading by CFD providers – that maximises the opportunities for triggering margin-calls and stop-loss orders, fuelling the avalanche of selling.

It is also possible for someone to intentionally spread false rumours to create a fall. Whilst this is effective, it is illegal and could result in prosecution, and it is not strictly necessary if the above steps are followed.

The Aftermath

This swindle results in a number of detrimental effects. Many of these are of course typical of any sort of wide-spread market manipulation.

Short-term Effects:

  • Investors are forced to exit long-term positions that they would otherwise keep and take losses at artifically depressed prices. Margin lenders may choose to remove these stocks from their ‘allowed stock lists’, forcing geared investors to pay out the entire debt on the share.
  • Triggering of clauses in commercial contracts that are conditional on the value or performance of shares in the company that has been ‘attacked’. This usually results in a win/lose situation for the parties to the contract. Examples: Cancellation of dividend reinvestment plans, derailing takeover bids and mergers

Long-term Effects:

  • Loss of morale amongst employees of the companies whose shared have been manipulated, as many employess receive shares or stock options as part of their remuneration.
  • Loss of faith in the integrity of the stock market
  • Increased bearish sentiment
  • Depressed economy and business confidence

Long-Term Remedies

Assuming that short-selling will be permitted again, the following remedies may prevent a recurrence of what has been happening:

  • Making identical information available to all participants

 All participants in the stock market should be entitled to obtain the same level of market depth information, whether they be stock brokers or retail investors.

  • Complete disclosure of all short positions

If a party is opening a short position, everybody should be able to see this this when viewing the market depth. For example, if I place an sell order to short 10,000 BHP shares at $40, this would appear in the market depth on on the offer side, with a symbol ‘S’ printed next to the quantity, so people know that I am not just a normal shareholder disposing of my stock.

At least once a day, the ASX should publish the total number of short positions in a given stock to allow participants to view the degree of bearish sentiment. This is already done for financial derivatives like options and futures. There is no reason why this should not be done for shares.

  • Banning of Naked Shorting

People who wish to short-sell a stock should be limited to the quantity of shares that have arranged to borrow in advance, even if their intention is to perform a day-trade. This would prevent attempts to ‘flood’ the market.

  • Accountable Stock Lending

Investors should be able to choose whether their fund managers lend their stock out to other parties. If an investor chooses to allow this, then they should receive their fair share of these profits as part of their income distribution.

Devil’s Advocate (Responses to Expected Criticism)

1.  Could the same argument be not be made about margin lending? After all, this allows people to buy shares with money they do not have, and many people do this for short-term gain as well.

The physical market is by definition asymmetric. There are a finite number of shares issued in a company, and people can either own some or not own it. The above logic would only apply if there were an equal number of long and short positions in the market.

The opposite of a stop-loss order is called a start-gain order, and there are very few of those.

This in contrast to the options and futures derivatives markets which are zero-sum games played between counterparties with opposing views.

2. Is this a conspiracy theory?

No, just an example of how intelligent people can find ways to exploit weaknesses in a system for their own personal gain. Think of it as cheating.

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