Will short-selling ban help – or hurt – banks?

Selling something you don't own might sound like a crime in any other walk of life. On financial markets, it's been standard practice for decades.

Not any more. On Monday morning, stock traders returning to their desks in London and New York will have to adapt to new rules: short selling, as it is known, has been banned for financial stocks. For the US market, that's through Oct. 2. For the British traders, the ban lasts until January 2009.

Authorities on both sides of the Atlantic took the drastic step late last week in an effort to prevent frenzied trading from putting any more banks out of business. This, coupled with a US plan to vacuum up all the bad mortgage debt in the banking system, generated widespread euphoria on Friday, sending the London's FTSE 100 index skyrocketing more than 9 percent in one day – its biggest ever one-day gain. The Dow Jones industrial average in New York closed down just 0.3 percent for the week, after a similar two-day rebound.

But with the dust settling on one of the most tumultuous trading weeks in living memory, questions are being asked about short selling and the decision to ban it. Were the short sellers really the scoundrels last week? If so, why is the practice allowed at all? And if not, will the ban really help restore confidence to markets traumatized by this escalation in the credit crunch?

Short sellers only make money if a stock price falls. They sell a stock they do not own in the hope of buying it back at a lower price in the future and pocketing the profit. Normally they borrow the stock, but sometimes they don't even bother to do that, a cavalier practice known as "naked" short selling. They typically prey on weak stocks, and their actions can become self-fulfilling if enough of them dump the stock.

Many in Britain have seized upon short sellers as the villains of last week's extraordinary events. The press characterized them as "sharks" and "greedy speculators." Short dealers were blamed not only for pushing down the share prices of US titans like Morgan Stanley and Goldman Sachs, but for pummeling Britain's largest mortgage bank, HBOS, such that it sought a buy-out rescue by retail giant Lloyds TSB.

For the authorities, it was clear something had to be done. Prime Minister Gordon Brown said on Saturday that he felt "the interests of savers and homeowners and mortgage holders came before the interests of a few hedge funds."

"There is a danger in a trading system which allows financial institutions to be targeted and subject to extreme short-selling pressures," said Sir Callum McCarthy, chairman of Britain's Financial Services Authority, "because movements in equity prices can be translated into uncertainty in the minds of those who place deposits with those institutions with consequent financial stability issues." US Securities and Exchange Commission chairman Christopher Cox added that the commission was "committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets".

But analysts warned that banning short-selling would only defer until tomorrow problems that needed to be sorted out today.

"My concern is that the regulators, by their actions to ban short selling, have done nothing more than prolong the agony," says Jeremy Batstone-Carr, an analyst with the brokerage firm Charles Stanley. "Financial institutions have got to go to the wall in order for the huge amounts of debt and leverage, built up over past two years, to be cleared."

Short selling is often considered a virtue inasmuch as it brings liquidity to the market, allows investors to position themselves appropriately, exposes bad management and amplifies company weaknesses for all to see. If the stock market is a gauge with a plus and minus reading, without short sellers, it's as if the needle can't read the minus side properly. "If by their speculation, speculators draw attention to the more deep-seated weaknesses in a stock, they are doing people a favor," says Mr. Batstone-Carr.

"It provides a hedging facility so that people can go into the market and manage their position," adds Justin Urquhart Stewart, director of Seven Investment Management. "It's a sensible way of operating, but it sounds like gambling so it gets a bad reputation,"

Some traders are adamant, moreover, that short sellers were not the mercenaries they were made out to be last week. Data shows that trading in HBOS was not particularly irregular.

"When you look the volumes of short selling in HBOS on the day, there was little trading that day," says Mr. Urquhart Stewart. "It was an unstable market and companies should have been suspended. That would have given time to look at alternatives and perhaps form a lifeboat."

"To blame the short sellers for the demise of these stocks does not give us the real picture," adds David Buik of BGC Partners. "Marketmakers, brokers, and fund managers have all contributed to the demise of these stocks. To blame it on short sellers is totally naive."

Ken Clarke, a former chancellor of the exchequer (the British equivalent of US Treasury secretary), said, "If you are going to find scapegoats, find the right ones: the people in the banks who just gave up traditional banking and stopped assessing risk and listened to young rocket scientists who took the debt off the balance sheet and engaged in creating investment vehicles that nobody really understood," he told BBC radio.

Some market players say that the ban will not end short selling but will just deflect trader attention to another weak sector like retail companies. Others warn that the ban will drain liquidity from the market, meaning that any trade in financial stocks will be amplified, contributing to volatility.

Other market insiders say that the move could actually hurt the bottom line of the very financial institutions that the authorities are desperately trying to help. Short selling is part of the everyday operation that sustains firms like Morgan Stanley and Goldman Sachs.

"I'm afraid the regulators have perpetuated the crisis," says Batstone-Carr. "I thought we'd be able to close the book, but now it's going to go on for a few more chapters yet."