I am always rather suspicious when talk of “morality” surfaces in the City of London. The London Stock Exchange crest may still be emblazoned with “My word is my bond” but the old world of gentlemanly capitalism died years ago, if it ever really existed.
But it is “morality” or lack of it, that is a word that financial institutions are repeatedly using when talking about the activities of people who engage in that nefarious low-down practice of short selling, in other words, turning a profit from share price falls.
Life insurers and fund managers are crying foul and casting them in the role of villains. They question whether it is right to reap a profit from a share price fall. Falls, particularly steep ones, can damage not just shareholders but also employees as businesses see their access to capital constrained and cut costs.
But those short sellers rub their hands in glee when companies hit the skids and make pots of cash by shorting them. Flooding the market with stock, by borrowing shares from a pension fund or index tracker with the aim of buying back at a lower price, the essence of shorting, can even enable hedge funds or other institutions to force a share price down.
Too much stock on the market and too few buyers and down go the shares. Some have even accused hedge funds of acting in concert to force the FTSE 100 index down so life insurers have to sell their shares in favour of bonds to comply with solvency rules, a scenario which would exacerbate a market slump and amplify the shorters' profits.
Are these criticisms justified? The hedge fund industry argues that it provides markets with valuable liquidity. They also reject claims that hedge funds have been behind a concerted effort to force down the FTSE or European markets. Industry bodies estimate there are some 4,000 to 6,000 funds managing around $600bn. They say only a limited proportion of these engage in short selling in the way I have described and that they simply do not have the capital to force down a market. Well, maybe. The fact is that it takes rather less money to move a share, or a market, than it once did and the amount of money controlled by hedge funds is going up at a fast rate.
Hedge funds can, and do, increase volatility. The problem, as with anything to do with hedge funds, is that hard facts are difficult to come by. It is all but impossible to say whether the insurers and fund managers have a point. Even industry bodies cannot provide reliable statistics on how much cash hedge funds control, much less what they do with it. Hedge funds are not regulated entities so it cannot even be reliably ascertained how many funds are in existence.
I have been a critic of the FSA in the past, and no doubt that I will be one again in the future, but this is one case where the regulator has got it right. The investigations it has conducted into short selling have been measured and conducted with an air of openness.
Banning short selling would be a foolish step, because it can provide useful liquidity. In fact, there is a strong argument for improving the regulations to allow sophisticated IFAs to be able to advise their clients better on funds which can take advantage of falling share prices, particularly in the current climate.
It would also be wrong to impose ill thought out and hastily drafted regulations.
Take the “uptick” rule used in some areas which only allows you to short after a share has risen. Given that share prices can bounce up and down within the space of a few minutes, what good does that do?
However, there is a need for light to be shined on an activity where there is considerable confusion and concern. The FSA seems to be moving towards forcing better disclosure. That is the right step to take. If the hedge fund industry complains about this, one might ask what it has to hide and whether the more mainstream fund managers and life insurers have a point.
James Moore is life insurance reporter at The Times