Hedge funds: Regulators come up short
The SEC and the FSA have both acted too hastily in reacting to short selling. In the UK, the new disclosure rules have compounded the turbulent mood of the market. Neil Wilson reports.
Was it ever thus? Perhaps it is simply human nature to seek a scapegoat. Certainly, it seems that whenever the markets are in free fall and losses are leaving blood on the Street, there is a scramble to find somebody to blame. And who are the usual suspects? Well, the hedge funds of course – those bad guys out there mercilessly shorting the hell out of stocks.
It was the case the last time markets plunged – in the wake of the tech bust, when equities fell more than 40% between early 2000 and early 2003. During that period, many listed companies and long-only investment institutions complained loudly about hedge fund behaviour, and some institutions even withdrew from the stock-lending market to try to counteract the shorters.
And it is the case again this time around in the wake of the credit crunch. Only this time, it seems that the regulators too have got caught up in the hysteria – with potentially damaging and counterproductive consequences.
In the US, the SEC imposed emergency rules this summer to restrict naked short sales in certain financial stocks and issued subpoenas to a long list of firms, requiring information on short-selling activity. And in the UK, the Financial Services Authority made two recent moves, the first requiring disclosure of short positions on stocks undertaking a rights issue, and the second requiring disclosure of synthetic long positions held via contracts for difference (CFDs).
While the SEC’s moves seemed to me excessive and unjustified, there was arguably nothing wrong with either of the FSA’s specific actions. It is quite right that sizeable short positions should be disclosed just as much as sizeable long positions – although the FSA requiring disclosure where a manager holds only 0.25% or more on the short side does not seem quite equivalent to the long side (where disclosure is only required at 3% or more). Arguably, it is also right that large positions held in CFDs – often held simply for reasons of tax efficiency (so that a fund avoids paying the stamp duty transaction tax) but also sometimes perhaps for sheer anonymity – should be just as reportable as outright stock positions.
But what was wrong, certainly with the rule change on disclosure of short positions, was the way it was pushed through in such a hurried way. Normally, if a regulator is contemplating a rule change, there is a process. The proposed new rule is published; there is then a consultation period in which comments are sought from the industry; then there are usually amendments made; and finally the new rule is implemented.
None of this process was adhered to in connection with the recent rule change on shorts in the UK. Instead, the proposed change was announced and enforced within a matter of days – allowing no chance for the industry to make considered comments or lobby for amendments. And why was that? Well, one reason the regulator gave was that in a highly stressed market, the FSA had to guard against greater potential for market abuse.
But it seems to me very hard to escape the conclusion that the highly perilous conditions in the markets had driven the regulator into a state of panic. As the head of one leading hedge fund group in London put it to me, with a strong note of indignation: "What market abuse? What evidence of market abuse is there?" No evidence of market abuse has come to light so far.
And what has been the effect of the change? Perhaps the ends would have justified the means – if the FSA’s move had indeed served to calm the turbulent mood of the markets. But sadly, of course, it is difficult to conclude that it had this effect.
Instead, the results appear to have been counterproductive. In the case of the recent rights issue by HBOS, the biggest mortgage bank in the UK, the enforced disclosure by major short-sellers only served to confirm that strongly performing hedge fund groups such as Harbinger and Lansdowne were indeed short HBOS in the midst of its battle to raise £4 billion in new equity. And the market seems to have come to the conclusion that, if smart guys like them were short, then maybe it really wasn’t something worth buying.
In the event, HBOS stock continued to languish below the offer price after the disclosure rules came into force, and the rights issue was a massive flop. Less than 10% of the offer was taken up – leaving the underwriters, led by Morgan Stanley and Dresdner Kleinwort, having to dig deep to come up with the money.
In a short space of time, therefore, the FSA appears to have put in jeopardy its hard-won reputation as a sophisticated regulator that really understands hedge funds – and the benefits they bring to markets. After all, markets require buyers and sellers in order to function smoothly; they are made an awful lot more liquid by active traders like many (if by no means all) hedge funds; and they benefit in particular from natural buyers when prices are falling – which is the way that those with short positions take profits.