Australia's share market watchdog has eased its blanket ban on short selling to allow investors trading the difference between share prices on dual-listed stocks to make covered short sales.

The move by the Australian Securities and Investments Commission (ASIC) largely affects funds trading in the dual-listed shares of top miners BHP Billiton Ltd/plc and Rio Tinto Ltd/plc.

Market operator ASX said on Tuesday the regulator would allow investors doing arbitrage trades on dual-listed stocks to use covered short sales on those stocks in Australia.

The term "short" has been in use since at least the middle of the 19th century and refers to the deficit position that a short seller has with their brokerage firm. The practice has been around for centuries and has often been used a scapegoat when financial markets are going through a difficult period.

The first recorded instance of short selling is believed to have occurred in 1609 when a merchant arranged short sales on stocks of the Dutch East Indies Company VOC which was listed on the Amsterdam stock exchange. This also prompted the first attempt to ban the practice. In 1610, directors of the company persuaded the government to declare shorting illegal as bearish speculators were "incommensurably damaging innocent shareholders, among which are widows and orphans". Illegal short selling continued anyway, so in 1689 the Dutch government imposed a tax on profits from the activity.

A similar pattern recurred in 1720 in Great Britain when the speculative South Sea Bubble burst. Shares in the South Seas Company jumped from 325 pounds to 1200 pounds as merchants rushed to acquire the rights to trade with Latin American countries. When shares in the company later fell to just 86 pounds short sellers got the blame. A law banning short selling was introduced in 1734, but as it was never applied it was repealed in 1860.

New York state unsuccessfully banned short selling in 1812 following heavy speculative activity that occurred at the outbreak of war with England but was repealed during the 1857-59 depression. The US government tried to rein in short selling in 1864 with the Gold Speculation Act, however in just two weeks the price of gold rose from $200 to nearly $300 and the ban was lifted.

Bank failures and panic in the British financial markets in 1866 was blamed on short selling and a law was passed forbidding short sales on banking shares. Once again the law was never used and testimony to a Royal Commission in 1868 showed that the problems had been caused by irresponsible banking practices and poor asset quality.

Short selling continued throughout the 20th century, but so did the animosity toward its practitioners. In 1929 such was the fury of ruined shareholders that one short seller had to hire bodyguards.

The very first hedge fund employed short selling as part of its strategy. Established in 1949 by Australian-born Alfred Winslow Jones with $100,000, the fund combined long positions on undervalued shares with short positions on overvalued shares. The early 1980's saw the creation of the first companies that specialising in short selling, and hedge funds with focus on the practice became more attractive after the stock market crashes of 1987 and 2000.

It remains to be seen whether the regulatory reaction to recent market hysteria is any more successful than previous attempts to curtail short selling.

ASIC has gone further than other regulators in banning short selling in all stocks not just financials. ASIC released a statement on Sunday (21 September 2008) banning all covered short selling in all stocks (subject to limited authorised market-maker exception). This ban is to be re-assessed after 30 days with possible rollback permitting covered short sales in non-financial stocks.

This action follows on from an ASIC release last Friday where the following 3 measures were implemented:
1. Banned all naked short selling.
2. Clarify, and in so doing, narrow the permitted class of covered short selling.
3. Introduce reporting regime for permitted covered short sales. 

Today, the ASX open was delayed 1 hour due to some confusion about how the ban would affect the hedging of existing positions. ASIC issued a statement effectively saying the ban does not require current short positions to be unwound or closed but rather prohibits any new or increase in net short positions. However, it is still unclear whether new short positions as part of hedging arrangements can be entered into, presumably this would be allowed for market-makers under the exemption mentioned.

Why has ASIC gone further than FSA & SEC?

Tony D'Aloisio, of ASIC, stated: "These measures are necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets. Because of the relatively small size and the structure of the Australian market, it is necessary to extend the prohibition to all stocks. To limit the prohibition to financial stocks, as has been done in the UK, could subject our other stocks to unwarranted attack given the unknown amount of global money which may be looking for short sell plays".

Further, ASIC emphasised that it sees a legitimate place for short selling in markets (e.g. to assist with price discovery). Mr D'Aloisio went onto say: "However, in the current climate and, in light of the actions taken by other regulators, we need a circuit breaker to assist in maintaining and restoring confidence. Our measures do that as they will operate for a limited time and in the case of non-financial stocks, will be reviewed in 30 days. In the case of financial stocks, the review will be in line with the time limits imposed by other international regulators such as the US and UK". 

Immediate Reaction

Predictably once trading opened the market rallied around 4%. Banning short-selling might result in a quick rally, but will it be sustained or solve the underlying problem? The rally will be more the result of false confidence and a "short squeeze" rather than fundamentals where those with existing shorts (i.e. apparently only hedge funds!?) will be forced to buy-back stock to close out their positions and limit or avoid losses. 

Solvency

With three statements in three days from ASIC it appears to be a quick and crude attempt to bandaid the prevailing market conditions. The fact remains that the current solvency situation still exists and is due to a number of factors not least the failure by Regulators to oversee complex financial products and the abusive application of leverage on company balance sheets. Initiating this emergency action could indeed lead to more uncertainty and panic as evidenced by the opening of the ASX. 

Liquidity, Price Discovery & Market Efficiency

Banning short-selling will ultimately reduce the liquidity, price discovery and efficiency of the market. While some may argue the effect of a reduction in liquidity will by minimal & outweighed by an anticipated reduction in volatility it is also good to remember that volatility is often associated with illiquid markets so you want to get the balance right. Additionally rather than adding volatility, historically short selling tends to smooth out price fluctuations.

Derivatives

Liquidity will also be reduced by the knock-on effect from the derivatives market where participants (other than the exempted market makers) will not be able to hedge their derivatives exposure (i.e. options or futures) by taking positions in the underlying market. Shorting is a widely used and legitimate tool in derivatives strategies to hedge risk (e.g. delta hedging).

Further, the ability to take short positions in CFDs is effectively stopped as CFD providers will be unable to hedge their clients' CFD positions in the underlying market. In the case of DMA (Direct Market Access) providers the stoppage of shorting will be immediate as these providers hedge via straight through processing into the underlying market. It is also likely the stoppage will be implemented by Market Makers as most hedge their clients? CFD positions on an aggregate basis.

Transparency

The ASX currently provides a daily list of what percentage of a company's stock is short-sold - it cannot be greater than 10% as per market rules. However, for full transparency short sales should be marked as such at the time of trade (e.g. just as cross trades are). Further it would be interesting and informative to see what percentage of daily turnover is actually attributable to short-sellers. Transparency is the key in averting a situation where fear overtakes, however unpopularly it may also reveal that the scapegoat (i.e. short selling and by proxy hedge funds) is simply just that - a scapegoat.

Hedge Funds

There is media speculation this could be the ruin of the industry. The short answer is No. The affect on hedge funds will most notably be in the area of equity-based strategies and particularly, market neutral, long/short, 130/30, convertible arbitrage, and dedicated short. With approximately 57% of hedge funds in Australia employing equity-based strategies the effect on performance could be noticeable over the next month. Some funds may choose to sit on the sidelines, reduce exposure or perhaps even unwind their positions (both long and short) so while the stock price of some companies might benefit others won't.

It is important for all to heed the gravity argument that "whatever goes up must come down" - maybe those in financial markets should rediscover this gem and get more in touch with their physical assets rather than those paper assets!

The US Securities and Exchange Commission (SEC) and the UK Financial Services Authority (FSA) have taken temporary and concerted emergency action to prohibit short selling in financial companies.

The prohibition bans the creation of a new net short position or an increase in an existing short position in publicly quoted financial companies. It applies to both naked and covered short-selling.

SEC Provisions

With regards to the US, the SEC action affects short selling in 799 financial institutions and is effective until 2 October 2008. The order may be extended beyond 10 days but not for more than 30 calendar days in total duration.

The SEC also has instituted the following:

Firstly, temporarily requiring that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities.

Secondly, temporarily easing restrictions on the ability of securities issuers to re-purchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.

FSA Provisions

In the UK, the provisions of the FSA affects short selling in 29 financial institutions and will remain in force until 16 January 2009 but will be reviewed after 30 days. The FSA additionally requires any net short positions in excess of 0.25% of the companies' ordinary share capital to be disclosed on a daily basis effective from 23 September 2008.

Hector Sants, chief executive of the FSA, said: "While we still regard short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, we have taken this decisive action, after careful consideration, to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector."

Jonathan Pain, HFA's Chief Economist and publisher of the Pain Report, has issued a special one page Special Edition in light of the extraordinary events of the past few days. In his report he outlines why he believes we are in a bear market that has further to run, and that the pain in Wall Street has now migrated to Main Street and the economic outlook has therefore worsened. For a full copy of his report, download the file below.

It seems almost impossible that the US can avoid a recession, and unlikely that Europe won’t suffer the same fate.  Australia might courtesy of our dual speed economy and distance from the storm’s epicenter, but that might depend on India and China avoiding the fallout also.  There are still some other train wrecks waiting to either happen or show themselves.  CDO’s may have become a well known terms in the last month, but watch out for Credit Default Swaps, Conduit Funds and Counter Party Risk joining the party.

Specifically for the Hedge Fund sector, there’ll be frantic activity as funds which used Lehman’s as their Prime Broker try to establish alternative arrangements, literally overnight.  Hedge Funds use their prime broker for a range of services, including trade settlement, stock borrowing, funding, trading platforms, systems and capital introduction.  Larger funds might employ more than one prime broker and will find it easier to switch, but for others it won’t be as easy. 

On a more positive note for Australian based funds, Lehman’s were not directly active in the local prime brokerage market, but it won’t prevent a tightening of credit lines and risk limits from the main Prime Brokers, the leading players in Australia being UBS, followed by Goldman Sachs, Morgan Stanley, ABN Amro and Merrill Lynch.

In reality there aren’t too many local funds over leveraged at present, but any change in a fund’s credit or other limits will certainly result in the unwinding of some trades, putting further downward pressure on markets.

Otherwise, some hedge funds (and their investors) will not only ride the storm out, but benefit from it also.  The local industry has a wide disparity of performance, with the majority not only outperforming the ASX200 year to date, but approximately one third handing in positive returns.  The volatility of the past two months, along with the sharp retracement of resource prices, will test some managers who thought the bull market would last forever.  With approximately 50% of results now in, the local industry is currently positive for August, with September shaping up to be an interesting month.

Absolute Return funds surveyed by InfoHedge have started to report their August results and preliminary analysis indicate that the losses experienced in July have been reversed. To date the average return for the month is +2.34% (funds reported so far approximate 25% of InfoHedge's database) compared to July's result of -2.11%.

The best performing strategies have been equity-based with these funds returning in excess of 3%. This result coincides with positive gains in the equity benchmarks with the ASX200 ending 3.08% ahead for the month and the S&P500 up 1.20%. The worst performing strategy was Commodities in line with a continuing retracement in those markets.

In results reported to date the best performing fund was PM CAPITAL Absolute Performance Fund AUD returning 13.70% using an Equity Long/Short strategy.

The below chart shows the monthly average return of all funds surveyed against the movement in the ASX 200.

July proved to be a challenging month for absolute return funds with nearly all strategies experiencing negative returns. The average return for the month was -2.11% in comparison to a fall of -4.78% in the ASX200 and -1.00% on the S&P500. This performance mirrored the June result of -2.01% bringing the average cumulative YTD return for Absolute Return funds to -4.15%. This contrasts to the equity benchmarks which still remain considerably lower for the year with the ASX200 down around 27% and the S&P500 down nearly 16%.

On a strategy / asset class breakdown the only funds to achieve a positive result were Equity Buy Write +0.12%, Fixed Income +0.13% and Carbon Assets +1.75%.

With a continuing volatile year across most markets and regions, the July 2008 YTD returns reflect that strategies in Commodities are performing best with Equity-based strategies the worst. On a geographical basis, North American mandates have fared better than locally-focused funds and those of other regions.

News of the decision by New York based Ospraie management to wind down its commodities based hedge fund could be causing some anxiety for local resource companies. Ospraie has reduced its holding in Iluka from 10.8 to less than 5 per cent over the last few months, but still holds 14.7 per cent of Mineral Deposits, 19.5 per cent of both Great Southern and Consolidated Rutile. A US service that can be used to work out who owns what says that there are at least 10 listed Australian companies whose share prices will come under pressure as the fund is unwound.

The 2008 Alternative Investment Management Association (AIMA) Awards were held in Sydney on Thursday 4th September recognising achievement and excellence within the Australian hedge fund industry.

The awards were well attended by industry participants and coincide with the annual Hedge Funds Rock charity evening supporting Cure Our Kids in raising funds for the Oncology Unit at Westmead Children's Hospital.

Over 200 funds were judged from which 15 finalists were chosen across 8 categories.

The Australian Hedge Fund of the Year was awarded to Fortitude Capital Absolute Return Trust, a multi-strategy market neutral fund specialising in Australian listed equities and derivatives.

Other awards included Mathews Capital Sabra Fund Best Long Short Absolute Return Fund; Bennelong Long Short Fund Best Market Neutral Fund; Kaiser Trading Fund SPC Best Global Macro/Futures Fund; Kapstream Absolute Return Income Fund Best Emerging Manager; and Investor Select Advisors Global Opportunity Best Fund of Funds.

TelstraSuper was rated the Best Investor Supporting Australian Managers and Kim Ivey, the Chairman of the Australian Chapter of AMIA, was recognised for his long-standing contribution to the Australian Hedge Fund Industry.