Proposed EU Short Selling Disclosure Regulations Bad for Large Hedge Funds and the Market

October 8th, 2010
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Contributed by: Simon Kerr
Proposed short selling disclosure regulations announced in the week before last by the European Commission (EC) are too stringent and threaten market efficiency in a general sense. Specifically, implementation of the regulations as currently drafted would be very damaging for larger hedge fund groups.

Shorting and Market Efficiency

Hedge funds, along with proprietary trading capital, dominate the shorting of shares. Day traders and individual punters short shares in the United States, but most shorting is carried out by hedge funds. A number of studies have demonstrated that the ability to sell short contributes to the accurate and efficient evaluation of financial instruments. For example the paper “The Importance of Short Selling”, published in September 2009 by the Asia Securities Industry & Financial Markets Association makes the case: In markets with bans on short selling, market participants with negative information that do not hold inventory of securities will be constrained from selling and their information will not be fully reflected in the prices of the instruments. Further restrictions on short selling can in this way increase the magnitude of over-pricing and subsequent corrections or reduce the speed of price adjustment to private information, according to this and other research. So impediments to short selling can impact market efficiency.

Disclosure to the Regulators

The newly created European Securities and Markets Authority will have the power to temporarily ban short selling altogether. It is proposed that investors will need to disclose short positions to regulators if they exceed 0.2 per cent of a company’s issued share capital, and to the rest of the market if the short position exceeds 0.5 per cent. The proposed regulations would also require that short selling of government debt be disclosed.

Visibility of short positions to regulators is not much of an issue. It will be something of an administrative chore to report all short positions greater than 0.2% to a regulator, and then all subsequent changes to such positions, but it is do-able. This new reporting activity will be part of the long-standing trend for compliance and administrative matters to be an increasing drain on hedge fund company profitability. Of more significance is the impact of public visibility of hedge fund short positions.

Disclosure to the Markets

Does this matter? Yes it does for market efficiency, but also because of the potential for more frequent and even more exaggerated short squeezes, and also for the impact on the managers' edge(s).

For a short position to be publicly visible it would have to be equivalent to 0.5% of the outstanding capital of a European listed company. Immediately I will look at the materiality of this level for hedge funds, and follow on with the impact it could have.

A key question becomes "How big would the fund have to be for the largest short positions to be visible to the market?” The majority of shorts amongst European equity managers are STOXX 600 Index constituents. Not that hedge funds don't short mid-cap names, but they have a profound preference to short liquid securities.

The smallest company in the STOXX 600, Europe's index of blue chips, Solarworld AG, has a market capitalisation of €1.008 bn. So a €2m short position in Solarworld would be known to regulators and a position of €5m would be known to the whole market.

The most concentrated equity hedge funds are "focus funds" which run with concentrated portfolios of what are considered the best ideas of a manager. Such a fund might have 25 long positions and 10 short positions with a gross balance sheet of up to 120% of equity. A typical balance sheet disposition might be, say 75-90% long and 15-30% short. This would make a typical short in a concentrated equity hedge fund 2-4% of equity.

Taking the larger end of the typical band, a focus-style equity hedge fund might have the largest shorts sized at 4% of the equity. If the largest short of a hedge was in the smallest of the stocks in the universe its significance for reporting is a function of the fund size. So a €100m concentrated-style hedge fund portfolio might have a €4m position in Solarworld, equivalent to 0.4% of the shares outstanding. That means the equivalent proportion short position would have to be 1.25x larger in absolute size to be visible to the market. Or to put it another way, the short position would be public knowledge at a 4% portfolio position for a €125m sized hedge fund.

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