Jeremy Warner's Outlook: Stock market has become the playground of speculators. Belatedly, the FSA is acting

The stock exchange is not there for the sole purpose of enriching the clever clogs of W1 so they can spend more time on the yacht
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The Independent Online

About time too. It's taken the sobering experience of the banking crisis finally to provoke the Financial Services Authority into a crackdown on short selling, but its actions are nonetheless welcome for being somewhat late in the day and comparatively limited in their scope.

It's a free country, so I guess we should resist the temptation to ban this faintly suspect practice in its entirety, satisfying though it might be to see the hedge funds of Mayfair deprived of their livelihood.

Yet banks are different. Once upon a time, it used to be illegal to short them at all, such was thought to be the damage that heavy short selling could do to confidence in the banking system. A concerted attack on the share price of a bank reinforces the view that the organisation might be in trouble and can therefore lead to a run.

But what's really got the FSA's goat is the way short selling is being used by hedge funds and others to break rights issues vital to the recapitalisation of the banking system and therefore the future of the economy.

For hedge funds, it's been the easiest money-making game in town – trounce the stock so badly through short selling that the issue gets left with the underwriters, then close the positions in the subsequent forced sale of the rump.

In treating the stock market as a playground for speculation, hedge funds seem to have forgotten its underlying purpose. Strangely, the stock exchange is not there simply to enrich the clever clogs of W1 so that they can spend more time on the yacht or at charity fundraisers with Tony Blair. Rather, its function is to raise capital in an efficient manner for the benefit of the wider economy.

The antics of hedge funds have been interfering with this vitally important process. In recent weeks, their actions have become doubly dangerous. Not only do short sellers threaten to deprive banks of new capital, but, if this kills confidence in banks more generally, it could be positively life-threatening to the organisations involved.

In both the case of Royal Bank of Scotland and HBOS, rights issues that began life as deeply discounted were whittled away by short selling to a point where there was a real danger of them being left with the underwriters. In the event, RBS scraped home, while yesterday's actions by the FSA may have helped save the HBOS issue.

In the latter case, the FSA crackdown has coincided with what counts in these markets as a relatively upbeat note on mortgage banks from UBS. Yet the UBS circular cannot entirely explain yesterday's 13 per cent surge in the HBOS share price. At least in part it was down to short positions being closed out for fear of discovery. Hedge funds would much rather make their money free of public scrutiny.

There was predictable uproar among the hedgies yesterday, even though the FSA's response is a relatively measured one. It might have been a great deal worse. In fact the FSA is asking at this juncture only for full disclosure of short positions beyond 0.25 per cent of capital.

Even the most zealous defenders of the right to short can hardly object to the introduction of this sort of transparency. As I say, this is a long overdue measure which might reasonably be applied, possibly at a slightly higher threshold, to all short positions. For now, the FSA is confining the new rules only to the period of a rights issue.

So far, so uncontroversial, unless you happen to be a hedgie, that is. The bombshell is rather in the FSA's warning that if enhanced disclosure doesn't work, it will consider other measures including the outlawing of stock lending during the course of rights issues. This would make short selling all but impossible, as market makers won't allow you to trade unless they know the stock can eventually be delivered.

It has always been a complete mystery to me why the big long-only institutions would want to assist short sellers by stock lending. Despite the fees they get from so doing, it seems manifestly to be against the clients' interests.

To the extent that there is an explanation it goes something like this. Short-term fluctuations in a share price are unimportant to a very long-term holder as eventually the share price will find its level. It therefore makes sense to try and make a bit of money out of these fluctuations by stock lending.

Well perhaps, but this justification fails to stack up where the effect of the shorting is to put the company's whole future in doubt. If they are not careful, some of these stock lenders might end up with no investment at all. What in any case happens to the fees earned from stock lending? If they help the fund manager beat the index and therefore earn a bigger bonus, then the practice becomes doubly dubious.

That's why quite a lot of long-only fund managers don't do it. The FSA was keen to extend these voluntary arrangements into the wider investment community, but strangely met with a marked reluctance from some practitioners. Compliance now looks as if it will be legally enforced.

The FSA would normally be obliged by law to consult on any change as significant as the new disclosure rules for short selling. The fact that it has not speaks volumes about the urgency of the situation.

The HBOS rights issue needed to be rescued from oblivion. What's more, any impediment to what may be a coming tidal wave of rescue rights issues as the economy slows had to be removed. The debt markets are already largely closed. If companies think they can't raise new equity either, we really would be in trouble.

There are any number of ways of selling shares you don't own in order to try and take advantage of perceived downside in the share price. It doesn't have to be done through short selling as such. Taking out an option to buy at a lower price achieves the same thing. But if you are not allowed to short, the process becomes more complicated and restrictive. By confining its actions to the specific instance of rights issues, the FSA is reacting in a proportionate way to a practice which threatens to interfere with the stock market's core function of capital raising.

Writing in The Spectator following his record-breaking fundraising dinner with Tony Blair, Arpad "Arki" Busson, a leading hedgie, says: "We've shown people that the hedge fund industry is a force for good in the world.

"In the past, my industry has been accused of everything from greed to carelessness and downright dishonesty. Now I feel a very different picture of us is emerging: working for others."

Yes indeed. If you catch a hedge fund trying to destroy a bank, you can at least be assured there are good, altruistic reasons – working for others. Arki is surely right. A sea change in perceptions is under way, and it may mean that next time the collection box is handed round, it won't be quite so full as the £25.8m raised at last week's bash.

Bank between a rock and a hard place

Mervyn King, the Governor of the Bank of England, will presumably already have penned the open letter he must send to the Chancellor next week if, as seems likely, inflation rises to more than 3 per cent. Mr King has said that he expects to write several of these letters in the year ahead.

The explanation for rising inflation is easy enough. Mr King can reasonably blame factors largely outside his control – rising energy, food and import costs.

Yet it is what he's going to do about it which is the more interesting question. The policy choice is looking increasingly polarised between simply allowing inflation to let rip and provoking a recession with interest rate rises. Not exactly an appetising dilemma, but, if Mr King is true to past form, he'll cite inflation as the greater risk.

All things are relative, however, and even the hair-shirted Mr King seems prepared to tolerate a period of above-target inflation to avoid recession. At least it has the merit of inflating away all that household debt.

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