Short selling is regarded as a controversial technique by many, particularly in times of falling markets. At the time of the credit crunch, National Governments around the world adopted different strategies to deal with failures in the world’s financial markets.
The responses of National Governments globally were generally aimed at restoring confidence in the financial system and with a view to preventing the systemic collapse of important financial institutions. As part of the solution aimed at restoring the orderly functioning of the equities markets, certain restrictions were placed on the practice of short selling.
At the height of market regulation in the UK and the USA, South Africa issued only one statement which said that it would not be introducing any temporary bans on the practice of short selling in South Africa. Part of this reason is that the South African JSE equities rules effectively prohibit naked short selling which is generally considered to be a far more risky strategy than covered short selling.
South Africa permits covered short sales which require a seller first to set aside time and resources to borrow shares before they are short sold. This reduces the speed at which short sales take place in the market and therefore reduces the risk of settlement failures. It also reduces the risk that more shares may be short sold than are currently in issue by a particular issuer.
Short selling is not a legally defined term and is generally understood as the sale of a security (i.e. shares) that the seller does not own at the time of sale.
Different methods of short selling are employed in the market; these are covered short sales and naked short sales.
Covered short sales usually entail a series of transactions involving the lending and borrowing of securities lending in order to settle short the position and complete the short sale obligation. Naked short selling, on the other hand, does not involve the setting aside or borrowing of securities first; rather a naked short seller sells shares that he does not own and places reliance on that number of shares being available in the market when he must close his position. In other words, a short seller who sells naked will sell shares without first having sourced the number of shares he wishes to sell short. In this way, naked short selling carries with it a settlement risk that covered short selling does not. A covered short seller will, of course, always face the risk that the original lender of securities recalls those securities before the covered short sale can be settled.
Short selling is also regarded as risky because it is inherently price sensitive. In relation to both covered and naked sales, a short seller is exposed to the risk that the shorted shares will go up in price. This is a risk to a short seller because the practice of short selling usually, but not always, relies on falling share prices. Short sellers will profit directly from falling prices but other strategies, such as pairs trading, will result in profits from relative price changes in different stocks. Pairs trading occurs where are trader shorts one security (S) and goes long (i.e. takes a long term view and generally owns) on a different security (L). The trader is effectively taking the view that that (L) security is underpriced relative to security (S) and will profit if (L) outperforms relative to (S) irrespective of the absolute change in price. So, in this case, in both a falling and rising market, they can profit from relative price changes.
If a share price goes up and the higher prices are sustained for long periods, short sellers will find themselves in what the market refers to as a “liquidity squeeze”, with the scramble for shares driving up prices even further. Conversely, short sellers will have information about shares that they think are overvalued. If investors over-react to that information, it can cause a flurry of selling driving down prices. In an ideal world however, short selling a highly liquid share should not affect the share price in a material manner.
Economic theory and many empirical studies of the financial markets support the view that short selling normally contributes to the efficient functioning of the market and is a legitimate investment technique in normal market conditions. In general, short selling can enhance liquidity in the market by increasing the number of potential sellers. It also increases efficiency by tending to increase trading volumes and reducing transaction costs. Market efficiency also generally results in more accurate price information by reducing the magnitude of overpricing and subsequent corrections of stock valuations.
Conversely, short selling can lead to potential problems in the market such as market abuse, disorderly markets, transparency deficiencies and settlement failures.