Short selling ought to have gotten easier in Europe since Wirecard AG filed for insolvency five years ago this week. The collapse spectacularly vindicated the Financial Times, which nailed the accounting scandal, and the hedge funds that had bet against the stock. But regulation continues to foster a bad environment for short sellers. Europe should beware of letting their craft die.
The supervision of short selling gets more stringent as you move east from the US. One major issue is the disclosure of short positions. The US favors aggregating these for public consumption. The UK is moving toward the same model. But in the European Union, individual positions of 0.5% or more must be revealed.
(Shorting is the sale of borrowed stock, aiming to repurchase it later when the price has fallen, profiting on the difference.)
Some might say individual short disclosure is useful information for the market as whole. But the costs of granular transparency outweigh the benefits. Exposing a hedge fund’s short in a stock may lead other investors to draw false conclusions. The market may automatically assume there’s a problem with the company in question even through the short could just be a hedge in some more complex investment. The risk is that the natural process of price discovery is hindered, not helped.
Alternatively, suppose a hedge fund has identified good reasons a company is overvalued. If the disclosure of the short pushes down the stock price, the hedge fund won’t make as much money on a well-placed negative bet if it later expands its position. So short sellers have to target larger companies to make money, or, where targeting smaller companies, be sure the downside is very large. That limits the shorts’ investable universe.
Add to this the specter of retaliation by the target company, or others with a vested interest in the stock going up.
Imagine a €10 million ($12 million) short position in a €2 billion stock. The share price has to fall a lot for the trade to be seriously profitable once the hedge fund has deducted all its costs — especially if these include hiring pricey lawyers.
Aggregate disclosure of shorts avoids all these pitfalls while still informing the market. The European Securities and Markets Authority reviewed the matter in 2022 following a consultation and decided against changing the 0.5% threshold.
If it’s hard to put on a short trade, it’s also hard to disseminate a short thesis. Europe’s MiFID regulation haplessly crushed the independent research sector it nobly aimed to promote. Reform here has come too late. The asset management industry has come to rely on investment banks for analysis despite brokers’ potential conflicts of interest as purveyors of services to both corporations and investors. Their “buy” recommendations vastly outweigh their “sells.” Yet each year, many stocks fall even if markets finish up. The UK published some creative ideas about boosting independent research, but the project appears to have fizzled.
Activist investors who take short positions and then publish their bear thesis are taking a meaningful financial risk. An accidental slip might expose them to accusations of market manipulation, which can lead to criminal proceedings. National regulators may choose to treat an activist’s published analysis as a regulated investment recommendation, subjecting the firm to the tougher strictures governing research produced by stockbrokers — even though the hedge fund makes money from investing its own and clients’ money, not from investment advice. All in all, the framework has a chilling effect on short sellers’ freedom of speech.
Not many investors have the combination of forensic ability and masochism to make a career of it. The risk is that the skill set becomes extinct in Europe. Who will hunt out fraudulent companies then? The financial regulators? They’re constrained by resources. Better that they see short sellers as allies in the mission to keep markets clean.
Aggregating disclosure of short positions would be an easy win but isn’t even a talking point in Brussels. German regulator Bafin, which hounded the FT for exposing Wirecard and banned shorting in the stock, nowadays sounds a contrite note. But concrete European reform to help short sellers is lacking. Will it take another Wirecard for that to happen? Let’s hope not.
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