FSA gives short shrift to hedge funds

The FSA is clamping down on the pesky traders who are currently making HBOS's life a misery...

Last Updated: 31 Aug 2010

The Financial Services Authority said this morning that from next week, all investors will be required to disclose any short positions greater than 0.25% in institutions that are preparing for a rights issue. The FSA reckons that when an institution is trying to raise cash by issuing new shares – like HBOS’s current £4bn offering – it ‘provides greater scope for what might amount to market abuse, particularly in current conditions’. Now it wants to name and shame the culprits…

Of course there’s nothing wrong with short-selling per se; it’s a perfectly legitimate (albeit slightly odd) tactic used by many hedge funds (and others) to bet on the price of a particular stock falling. They do this by borrowing shares from existing shareholders, in exchange for a small fee, and selling them on the open market. If the price does fall, they can buy the shares back cheaper and return them to the original owner, pocketing the difference as profit. But if it rises, they make a loss.

As the FSA said today, short-selling ‘assists liquidity’ (because the more shares there are on the open market, the fairer the share price is likely to be). In fact, it provides a useful function in the financial markets, by preventing prices going too high. If a trader recognises that a particular stock is over-priced and correctly predicts that it will fall, why shouldn’t they make a profit on it? It’d be like legislating against people who bet against England qualifying for major football tournaments…

But it’s a bit different when it comes to rights issues. HBOS has blamed short-sellers for the billions of pounds wiped off its share price in recent weeks as it prepared for a £4bn rights issue. And you can see the problem: why shouldn’t people short the stock, when they know it will be available at the offer price in a few weeks’ time? This creates a downward spiral which has sent the share price below that offer price, giving the hapless underwriters a £4bn headache.

Of course the easiest way to stop this happening would be if the institutions that lend out the shares – usually pension funds and insurers – stopped doing it. After all, if the shares in the big banks slide, they’ll almost certainly end up out of pocket too. But they appear to be strangely reluctant to do this. So instead, the FSA is betting that if investors have to disclose positions bigger than 0.25%, chances are that their bloodthirsty rivals will conspire to drive the price up, to ensure they end up losing money.

Then again, a 0.24% short position in something as big as HBOS and RBS can still be a nice little earner – so don't go feeling too sorry for those hedge fund types in Mayfair...

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