Fund Managers to Fight Short Selling Disclosure Rules

Fund managers are gearing up for a fight regarding short selling disclosure rules (see Financial Times article). The FT article discusses how the fund industry would be damaged by such timely and public disclosures, basically arguing that no one would pay for investment advice or money management when the relevant information can be had for free a day or so later. Yet, this argument may miss the most interesting point - that a ban or disclosure rule is certain to have some unintended consequences.

Bans on short selling have had a goal of trying to limit funds from manipulating the market, but making short selling positions public could just exacerbate the problem. Non-public disclosure would allow regulators to monitor positions and funds, insuring that market manipulation was not occurring, yet by making the short data public, others would now be tempted to jump on the momentum train, increasing their short positions, and the selling pressure on the shorted security. In the end, this may do nothing to decrease market manipulation, while still allowing the funds to profit from the falling prices.

If increased selling is the potential fall-out of public disclosure, then why should funds care? I suspect there are two reasons. First, if they are taking a large (but allowed) short position, it may take more than a day to enter or exit the position. One day of disclosure could potentially reduce the profitability to the fund as others front-run the trade. Second, and maybe more critical, is that any short momentum trades that result in a large sell-off or company failure will still ultimately get blamed on the funds, causing regulators to once again implement short-selling bans. For the funds that have strategies that rely on being able to take a short position, such a ban affects viability as much as it does profitability.

Currently, longer disclosure periods are being discussed, such as two weeks or even a month. While this may help with the first problem of having enough time to enter and exit a position, it will do less for the second unless the disclosure period is long enough to limit profit opportunities for those who later try to mimic the trade. Too short a disclosure period, and you encourage copy-cat trades and additional selling pressure. Too long, and the disclosure simply becomes a record of what companies were short. Anything in between provides the potential for market manipulation with little benefit to market efficiency over what non-public disclosure would most likely offer.

Comments

[User 283977:]

The issue with shorting concerns its potential for market manipulation. If you have deep pockets, you should be able to drive a securities price down by large volume, long term continuous shorting. The long term aspect of this is very important because if the price falls fast enough over a few days, we get a band wagon effect as other people dump their stock. Now you quickly buy to cover, and you have a profit. Because the other sellers are behind the timing curve, they eat it. Of course, the companies financial position can also be damaged.

I suspect that band wagon effect would be more likely to occur if the short selling was consistent over longer time periods. And in fact, if you were trying to manipulate the market, you would want to be doing it over an extended period of time. This is why the Fund Managers saying they did not want any timely public disclosures raises a red flag.

I think the potential for market manipulation by shorting needs to be controlled. I think the best way to do that is not through timely public disclosures but through volume limits. You can sell as many shares that you want to if you actually own the shares. But if you are shorting, then some type of volume limitation would reduce the probability of creating the band wagon effect. I simulated it, and it seemed to work. Is there some other way to prevent market manipulation through shorting?

Jan 07 04:26 PM

[wocojoe:]

A simple solution 1) reinstate the uptick rule, 2) either they fess up to what they are shorting, or we simply ban it altogether. Puts and Calls were supposed to help remove market volitility, but add if some one can short sell too, then you have to few controling to much for pure greed and market disruption. We would all be better off without Short Selling, puts and calls.

Jan 07 04:29 PM

[happysoul77777:]

The mutual funds are required to report their long postions. Hedge funds should be required to do the same.

The reporting should help reduce naked short selling. It will help restore confidence to the market.

Jan 07 04:39 PM

[nmelendez:]

The problem with puts, calls and spreads is they eat the profits on 401k's. 401k's were suppose to be vehicles for retirement. However as many have pointed out, the stock market is not a retirement vehicle. It's an INVESTMENT, and as such you may make a million or lose your shirt. That's the real problem. The US needs to go back to the old retirement principle or establish a national retirement system. Until this happens, retirement accounts are going to be eaten alive by the stock market. Federal employees alone have over 600 billion in theirTSP retirement system based on the market.

Jan 07 05:26 PM

[Kaboomba:]

The real problem embedded within our system lies at The Stock Clearing Corporation where every day billions of dollars worth of equity trade "settle" without actually delivering real shares. To explain, I purchase "shares" in company X that appear in my account immediately. T+3 they settle the trade by deducting money from my account. Daily, TSCC chooses to issue IOU's in lieu of actual shares. The IOU's look exactly like real shares and because of this I have no way of knowing if good delivery was made or not. This is intentional fraud justified by regulators as "necessary to maintain orderly markets". I ask what ever happened to basic property rights? Who are our regulators kidding when they claim to promote transparency? Basic property rights demand that I get what I bought---not and IOU. Transparency demands that I be informed about the fictitious shares. In this light I feel that A. Tell me if my property i/e shares have not been delivered in good form, B. Allow me the authority to force a buy in which presently sits with the brokerage firm, C. Demand that my monies be left in my account until I get what I bought. It seems so obvious yet over the last decade of excessive leverage and greed basic property rights have been trampled on to the collective amount that reaches into the trillions. This system makes Bernie look like a pauper! Currently TSCC is owned and controlled by a select group of securities firms that have profited greatly by perpetrating this fraud on unsuspecting and uninformed investors and IT MUST BE STOPPED!

Jan 07 08:09 PM

[Chuch:]

Obama has some serious time ahead of him, banks are going to struggle. Especially competing with these new P2P lending sites like the one this guy talks about at www.crashmarketstocks.... .

They sound like they get pretty big returns

Jan 07 11:26 PM

[Moon Kil Woong:]

Mr. Lunn. I suppose that never happens with long positions. In fact, fund managers regularly window dress and try to create upward momentum on stocks they own which are thinly traded. I am not against disclosure, however, disclosure down should also be disclosure up as well if your goal is to prevent market manipulation. Otherwise it is gives the appearance that government wants to keep witch hunting and punishing those who rightly see overvaluation.

Short selling holds an important part of the market. It helps keep companies honest, enables hedging, and often it is the only cash reversing itself and buying after the market collapses.

Regulating shorts won't prevent a Madoff. Properly regulating and monitoring mutual fund managers will. To start I recommend they verify fund managers actually have the assets they claim they do. If they can't even do this good luck doing anything else.

Jan 08 12:55 AM

[User 283977:]

Constructe - My comment was specifically directed towards shorting which is the focus of the article I was commenting on. Yes, I agree it is essential that fund managers have the holdings they say they have. I also agree that regulating shorts will not prevent a Madoff. However, preventing a Madoff is not the focus of the authors article.

Jan 08 11:30 AM

[suolucider:]

So what your basically saying is that if they have to make their short position public they will no longer have the ability to control the market and will affect their profits since it would level the playing field and put them at the same status as the rest of us. What a sham of an article.

Jan 08 11:54 PM