David Lewis, FIS’ senior director, securities finance and global head of Astec Analytics, reflects on regulators’ guidance for short sellers and efforts to ensure a fair and transparent marketplace
Mathematics, science and financial markets have much in common. They all rely on process and formulae to deliver predictable results, but almost always with caveats. For example, patterns of physical behaviour, such as acceleration due to the force of gravity, are described with certainty by physics equations and rules but with the additional quirk to cover the unknown or difficult to measure (e.g. friction). In the absence of friction, do X and you will always get Y. All you have to do is work out what impact any friction has on the result.
Financial markets, and indeed any market for that matter, suffer from similar issues but the caveats are applied by economists, not physicists. For example, a perfect price for an asset can be obtained, but only in the presence of perfect information for all buyers and sellers and, of course, with no transactional friction. It is this utopian position that many governments and regulators strive for, through prudential or prescriptive regulations and policies.
Perfect information
Perfect information is a favorite of many regulators and, to ensure a level playing field among all investors, they work to exclude unfair advantages while also eradicating poor behaviour. Recent debacles that have had rarely seen impacts on the market and its participants, large and small, include extreme volatility in GameStop shares, as well as in the value of Dogecoin and Bitcoin.
Seemingly throw-away comments by major industrialists on the validity or acceptability of either of these cryptocurrencies with regards to their future position in financial society, or whether they might accept them as payment for their products, has sent their value soaring and plummeting with frightening results.
Dogecoin, for example, was worth 0.8 of one US cent ($0.008) apiece in January 2021 but had peaked at over 72 cents ($0.72) in May. Bitcoin is on another level of magnitude, trading at around $36,000 each in January and advancing to over $62,600 by April. Not the stellar rise seen by Dogecoin, but significant nonetheless, particularly as the value is back where it started in January.
Some have alleged wilful market manipulation, and this has yet to be proved of course, but such activities are bound to come under scrutiny from regulators. Short sellers are no strangers to such attention, having their actions outlawed in some countries in times of market stress, and increasingly regulated in others when unfair behaviours are alleged.
Short and distort
Many activist investors, such as Citron Research, Muddy Waters and others, who have uncovered significant wrongdoing at companies they have researched and taken positions against, attract the attention of regulators that fear market manipulation by those with an unfair edge on information.
The Australian Securities and Investments Commission (ASIC) has released a new set of guidelines and best practices for short sellers operating in its markets. INFO 255 lays out the regulator’s expectations for acceptable behaviour without, thankfully, banning the insights that intelligent research can bring.
However, there are more than a few areas for concern within the best practice that might raise eyebrows with some and will raise questions about the equal treatment of those positioning to benefit from an undervalued asset compared with those taking positions against one that is overvalued.
“Short and distort” is both an unattractive statement and behaviour somewhat akin to the mirror version of “pump and dump” promoted in the film The Wolf of Wall Street. ASIC is right to attempt to root out those wanting to distort the marketplace with unfounded negative statements on companies that they have already taken a short position against, just as it should seek out those making falsely positive claims about the value of equities and other securities.
Price discovery
The guidelines include recommendations to avoid unacceptable levels of market volatility by only releasing such research outside market hours so that the targeted company has time to respond to any allegations of wrongdoing before any selloff begins. It also recommends that such research be based on facts and is not unfairly imbalanced toward negative aspects of the share issuer’s financial health. Somewhat less realistic, however, is the suggestion that the research publisher fact checks with the entity they are releasing research about before publishing their findings.
If short selling, and the research behind it, is to benefit the level and accuracy of price discovery in a market then forewarning those that are suspected of misleading that market seems out of step. Most regulators around the world have multiple layers of regulations regarding the publication of financial statements and research, including the need for accuracy of any claims or statements, which should be applied equally to both the long and short side of the street.
To unfairly restrict the sceptical side of the market will create an imbalance, attracting capital and resources to companies that should not benefit from them and delivering equity valuations out of step with reality. All these factors harm investors and the market overall.
Public disclosure of short interest data, supported by many exchanges around the world, goes someway to remove the belief that short interest data is tantamount to insider information. ASIC suggests that they can be comparable when the short seller/activist researcher has information on, or even just an opinion on, the value of the company before that data is made public. Insider trading is, and should be illegal, but the same tests and controls must be applied to both sides of the street for it to be effective and transparent.
The Australian regulator does recognise that some activist short sellers have uncovered flawed businesses, insolvency and even fraud, but remain fearful about the potential of “short and distort” campaigns where perfectly viable companies are targeted for short term gains as investors react to overly negative research.
There is no doubt that research firms and influential individuals with a significant following can move asset prices and even whole markets with little more than an opinion, whether published with diligence or maleficence. It is the unenviable task of regulators to balance the flow of market data and police its veracity to ensure fair, orderly and transparent marketplaces for all.
