The Financial Sector Conduct Authority (FSCA) is asking for public comment on a second version of proposed measures to regulate short selling of listed shares after feedback on the first draft of the rules forced it to largely rewrite the document.
The second draft looks better – but apparently exempting international stockbrokers operating in SA from the new rules will make the new reporting standard ineffective.
It seems that contracts-for-difference (CFD) brokers are also excluded as they only offer exposure to price movements of listed equities and do not trade the shares themselves. Thus, CFD brokers do not need to disclose short sales and clients can enter into uncovered short sales.
When it started working on the new regulations years ago, the FSCA made reference to the global financial crisis
“During the 2008 global financial crisis, several countries implemented emergency measures in relation to short sales because of concerns that this activity was aggravating the downward spiral in share prices, thereby posing a threat to individual financial institutions and wider financial stability.”
Various measures, from restricting short sales to temporarily banning short sales in certain sectors, were taken. “Other measures included introducing a requirement to flag every short sale on the exchange trading system and the reporting and disclosure of net short positions at certain thresholds.”
Nothing short of disaster …
Some people will remember the billions earned by short seller Bill Ackman when the sub-prime mortgage market in the US crashed in 2008.
Another historic short position was when George Soros short-sold $10 billion worth of pound sterling in 1992 and forced the pound lower.
The Bank of England couldn’t borrow more money to buy pounds to prop up the value, effectively borrowing – at a high price – to sell pounds to Soros.
Soros made $1 billion when the pound crashed and he covered his short.
Shorting has a place …
The FSCA admits that short selling is not all bad.
“Short sales are beneficial to the market in that they also contribute to market efficiency. Short sales play an important role in financial markets and are undertaken by a variety of market participants.
“They also contribute to efficient price discovery, increase market liquidity and facilitate hedging and other risk management activities.”
However, the document published for public comment on a new Conduct Standard for Short Sales points out that “the risks associated with short sales cannot be ignored”.
The risks
There are a number of risks associated with short sales, including:
- They may be used in an abusive manner to drive down the price of securities to a distorted level and may contribute to disorderly markets (especially in extreme market conditions);
- They can have an adverse impact on financial stability;
- They may be used to contribute to market abuse as sales add incremental weight to a downward trend or support insider trading by those with adverse information about a company;
- They can be used abusively to create misleading signals about the real supply of shares or the correct valuation of a security;
- Price abuse can reduce the ability of a listed company to raise equity capital or borrow money, and if bank shares are involved, it could affect banks’ ability to attract deposits; and
- Naked short sales give rise to the risk that the seller is unable to deliver securities to the buyer and thus impairs the functioning of the stock exchange.
The FSCA says its new proposed regulatory framework will also provide early warning signs of a build-up of large short positions in a specific share and warn authorities of potential market abuse or developing market risk.
Reporting
The new rules require that brokers report all short sales as such and that the relevant stock exchange publish the number of shares sold short for every listed company, and calculate the percentage of shorts relative to a company’s issued shares.
The first draft of the new rules proposed that short sales be flagged on trading systems as short sales at the time the order is placed – but that turned out to be impractical.
Brokers commenting on the draft regulations said they merely execute a sell order and would not always have insight as to whether the sale is a short sale transaction, because their clients might not disclose it as a short.
They also said that naked short-selling is already prohibited.
Pros and cons of new draft
Dawid de Villiers, partner at law firm Webber Wentzel, says the new draft of the Conduct Standard explicitly prohibits uncovered (naked) short sales.
“The FSCA believes that transparent short sale reporting will enhance market integrity by helping to track the level of short selling in specific securities, provide insight into share price movements, offer early warning signals of a potentially overvalued individual securities and build investor confidence by reducing uncertainty.
“Enhanced transparency of short sales offers significant informational benefits for the market, which are expected to outweigh the associated compliance costs,” says De Villiers.
“The measures contemplated in the New Draft Conduct Standard aim to discourage aggressive, large-scale short sales that could disrupt orderly markets or lead to market abuse.
“Additionally, the early warning signals of a build-up in short positions will assist regulators in identifying and addressing potentially abusive behaviour more effectively.”
The South African Institute of Stockbrokers (Sais) believes short selling is more likely to have a positive effect on the market in that it increases liquidity.
But it does have concerns about the new proposals.
“The largest risk in short selling, in our opinion, is the recall of loaned securities, and volatility and price fluctuations as a result of short squeezes,” it says.
International brokers
Another big problem for Sais, also mentioned by other respondents during the first round of public participation, is that it would be impossible to get international brokers operating in SA to comply.
The FSCA admits to the problem.
“Foreign clients often utilise foreign firms, as opposed to a local financial institution, to manage or hold the client’s portfolio, even more so where a foreign client uses a foreign firm that does not make use of a local branch,” it says in the new draft rules.
“Even if the foreign firm owns or has some other association with a local authorised user, that authorised user is typically only an execution agent for the foreign firm.
“The local authorised user will typically not know who the foreign firm’s underlying clients are and they are unlikely to know whether the foreign firm holds a short position either for itself or on behalf of an underlying client,” the FSCA adds, apparently exempting international stockbrokers from strict compliance.
The result is that short sales by foreign clients will not be reported accurately.
Capitec – a test case in point
The new Conduct Standard would not have prevented the dawn raid on Capitec in 2018 after an unemployed British social worker and two Australians built up a large short position in Capitec shares.
The three touted Viceroy Research as a big research house and sent copies of their “research” to as many stockbrokers and media outlets as they could.
The report was later found to be based on false accusations by former clients and (deliberately) inaccurate calculations, but Capitec’s share fell more than 20% from above R1 000 to R835.
