UK should implement post-Brexit short selling reforms to boost markets.23 Mar 2023 11:01
The UK has taken a welcome step to remove all the unnecessary burdens stemming from often ill-considered EU regulations and design a short selling regime that contributes to strong and sustainable growth.
Jeremy Hunt, the Chancellor, has asked for opinions on how short selling regulation in the country should be improved as part of the so-called ‘Edinburgh reform package’ to strengthen the City of London. The UK should start repealing the nonsensical EU requirement to publicly disclose short positions by the parties that took them.
This artefact of EU regulatory overstretching is exactly the kind of reform a post-Brexit Britain should be pursuing. The requirement discourages short selling – the practice of selling borrowed shares in hopes of profiting from a price drop – and distorts trading.
Short selling sometimes draws rash criticism, often from companies trying to ward off damning revelations uncovered through research by short sellers. But it benefits markets by improving liquidity and stability while increasing investors’ appetites to take ‘long’ exposures by allowing them to hedge risk.
For example, if an investor believes a company is well run and wants to go long, they may short other companies in the same industry to hedge macro issues affecting it. This way, the investor has more tolerance for taking the risk on the long side.
In times of dislocation, short sellers who close positions are among the only buyers and can help set a floor below stock prices. Research, conducted after brief bans during the financial crisis and the Covid-19 pandemic, shows that the ban on short selling reduced liquidity and did not benefit share prices.
EU rules may also distort trading by encouraging high-profile investors to sell heavily if their positions exceed a disclosure threshold of 0.50 percentage point of a company’s equity. The incentive is to take a larger position before the disclosure is made public. Nobody seems to benefit from this.
Experience has shown that many companies limit communications with investors who they believe are shorting their stocks. In other words, the practical effect is to create a two-tier communication system for investors that discriminates against short sellers.
An example of the distortions that can arise is the short-lived rise in GameStop shares as speculators went long in the retailer following the disclosure of short EU positions held by hedge fund Melvin Capital. The hope of some speculators appears to have been to trigger a squeeze and force short sellers to buy shares and push the share price higher.
The squeeze attempts lead to an interesting consequence of this discussion: the UK’s new framework should clarify that recalling borrowed shares for the purpose of effecting a squeeze is manipulation. Squeezes are often price distortions that can catch long positions flat-footed and certainly impair willingness to take short risk.
Is there a valid reason for the EU’s disclosure requirem
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