Are short sellers to blame?

With markets plunging into oblivion and pension funds nursing heavy bruises, the search has been on to find the real villain of the piece.

It was not a long quest: many say the blame lies with the only people who seem to be making any money out of the stock-market misery that is destroying everyone else.

In the past few weeks criticism of so-called "short sellers" has reached epic pro- portions, and the market is now looking to the Financial Services Authority (FSA) to douse the flames.

Short selling is by far the most popular way of making money out of falling markets. It involves borrowing stock and selling it in the hope of buying it back at a lower price and pocketing the difference. Supporters believe it is a useful way of keeping markets liquid – a view cautiously backed by the FSA.

But the main gripe is that short selling runs counter to the spirit of capital markets: they are there to raise money for companies and investors and therefore represent more than just a convenient collection of tradable derivatives. Critics have also accused the short sellers of exaggerating downward market movements, making it a trading environment with far less correlation to stock fundamentals, and far more risk to regular investors. The jury is still out on that one, but the fact that there is no absolute evidence is one of the FSA's chief arguments in favour of greater disclosure.

Some of the more tacit criticism has been reserved for hedge funds, the biggest proponents of the dark art of short selling. As well as doing their work in what many see as the market shadows, they tend only to be open to bigger investors. With minimum investment requirements aver- aging around £100,000, smaller punters are simply priced out of "going short".

For their part, hedge funds vigorously defend their right to short, as one London-based manager explained: "Everyone agrees that markets are there to make people richer, and that's what we're doing. A prediction that the markets will go down is just as valid as the other way round."

One of the biggest critics is Legal & General, whose chief executive, David Prosser, has launched an attack on short selling and the way it hurts savers. His proposal is to impose a tax on short selling that might discourage it.

Mr Prosser's company is also the first to put a stop to one of the fundamental parts of short selling, stock loaning. When short sellers sell stock, it has to be borrowed from people who own it, and many pension funds end up in the position of lending stock – at a tiny commission of 0.2 per cent – and then receiving it back at what is usually a lower value. Other big asset managers have indicated they might join L&G in this stance.

The FSA, whose solution is to schedule a forum for September, wants short selling to be better policed by being more transparent, particularly in allowing the market to know the size of stakes created by borrowed stock.

But it may come too late to be of much use to the smaller investor. Nicola Horlick, head of SG Asset Management, believes short selling is here to stay, offering pension funds much greater levels of flexibility. "What it does show very clearly is that it is all getting too complicated for individual investors. Short selling means that volatility is that much greater now and you have to be watching the screens all the time," she said.

Leo Lewis