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Investment view

As markets continue to gyrate and evidence of increase in stock-specific risk accumulates, it seems rather appropriate that the FSA should publish a document on the thorny issue of short selling. With such mighty companies as ABB losing 60 per cent of their value in a single day, the drivers behind current volatility are surely overdue for examination. Quite whether the regulator will be able to introduce a system acceptable to all participants in the market is another matter entirely.

Short selling has been around for as long as share trading. Back in the days before Big Bang, when settlement was based around an account trading system that divided the year into 24 periods of two or three weeks, short selling for brief periods was easy.

All trades carried out within the account period were matched so you could sell at the beginning of the account and buy back later, avoiding stamp duty and receiving favourable commission treatment. Rolling settlement made this more difficult (although not impossible) but it is the development of the derivatives market and the massive growth in the practice of stock lending that has fuelled the appetite for selling short.

Stock lending – the practice of “lending” shares or other securities to facilitate the settlement of a trade – has also been around for many years but in its early days was primarily confined to the British Government securities market. Settlement periods for gilts were always tight so the availability of someone to provide certificates on a short-term basis was welcome. The jobbers, or market-makers as they are now known, also often had recourse to this market but, as short-selling practices increased, so the ability to borrow stock in an increasing range of ordinary shares developed also.

Behind much of the short selling that goes on is the contracts for difference market – or CFDs as they are known. A CFD is a derivative instrument that entitles you to buy or sell the movement in a company&#39s share price. In other words, you do not own the shares themselves, merely any change in price that takes place subsequently. CFDs have many advantages for traders. They are not subject to stamp duty while commission is generally lower than those applied in the cash market. CFDs are also behind the spread betting market – another arena which is seeing massive growth in the number of participants.

Hedge fund operators, often charged with being the perpetrators of short selling, will also take advantage of these derivatives instruments but the regulator, in the paper it published, stated that it does not consider short selling to distort the market overall. Rather, it adds to the speed at which reactions take place. Remember, too, that market-makers these days are likely to be divisions of banks – not known as risk-takers in a market where being caught wrong footed can result in massive losses.

Other countries have reporting systems that at least show the extent of short selling in overall market activity. Detailed reporting would, though, prove difficult, as it could enable those who wish to profit from the activities of others to exert a squeeze on the sellers. It is worth bearing in mind that short selling is inherently more risky than owning shares. If you purchase a share at one pound, your loss is limited to the price you pay. Sell a share at a pound and in theory the loss could be as much as it costs you to buy back the shares.

There are many examples of effective bear squeezes taking place – including one where a particularly wily operator succeeded in purchasing more than the issued share capital of a small mining company. The short sellers were held to ransom because they were unable to buy stock in the market to cover their positions.

While this is perhaps, an esoteric subject for the average private investor, it is worth understanding the dynamics of what is happening. Short selling has added to volatility, much as the different structure in the market and the technological advancements that have taken place have also served to increase the speed at which share prices move. We must learn to live with the situation that has developed. But it does no harm to understand why these things happen.

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