Credit Crunch: Why ban short-selling?

The Financial Services Authority's (FSA) ban on short-selling in financial stocks - in which traders look to profit from falling share prices - came into force today. Here is a guide to the practice.

What is short selling?

It is when someone borrows shares in a company and sells them in the hope the prices will fall. The aim is to buy it back at a lower price in order to return the stock to the original owner - pocketing the difference as profit.

What exactly has the FSA done?

It has banned traders from creating new short positions and increasing current ones in listed financial companies. The ban will remain in force until January 16 next year, but is subject to review in 30 days' time.

The watchdog is also ordering all investors "shorting" more than 0.25 per cent of a financial company's shares to reveal their positions on a daily basis from next Tuesday.

Why has it acted?

FSA chief executive Hector Sants said the move is to "protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector". It also follows accusations that short-selling was responsible for driving the run on HBOS shares earlier this week, which led to it agreeing a rescue deal from rival Lloyds TSB. On Wednesday, HBOS's share price plunged around 70 per cent from their opening at the start of the week, and Scotland's First Minister blamed "spivs and speculators" for effectively forcing the takeover.

Who can short shares?

Anyone can short-sell a company's shares, but hedge funds are the main participants. To short you normally need someone to borrow the stock from, and this is often done by big institutions like pension funds and investment banks.

Does the practice automatically apply pressure to a share price?

Not necessarily. For any party going short, there needs to be another party who believes the shares will not fall. But if there are rumours about the well-being of a particular company, then this can ramp up short-selling which can then increase further increase the fears for the firm in question.

Has the FSA acted against short selling before?

Yes. It acted in April when HBOS shares slumped 20 per cent as it was trying to raise £4 billion of new capital. There was speculation that unscrupulous traders had short-sold the stock then spread false rumours about the group's funding position, hoping to drive down the share price and make a profit as a result. The FSA stepped in to warn explicitly against the practice and launched an investigation. Reports spoke of anonymous emails spreading through the City and one trader making as much as £100 million from the ensuing HBOS turmoil. In June, the FSA also issued a new regulation that required investors shorting 0.25 per cent or more of a firm undergoing a rights issue to tell the market.

Are short sellers to blame for the recent HBOS share slump?

Most analysts say no. They argue that the shares fell on underlying fears over the bank's funding position. Analysts said HBOS was facing more than £100 billion of refinancing over the coming months, which could have been more challenging in the wake of the turmoil from the collapse of US investment bank Lehman Brothers. The cost of bank borrowing also rocketed in the past few days, applying more pressure to HBOS results.

What happens to bank shares now?

Shares rose sharply today amid hopes the move will remove some of the uncertainty surrounding the sector. But some analysts are worried that liquidity will now dry up in financial stocks so that any buying or selling of the affected companies will have massive ramifications on the prices of the companies concerned. And they add that the underlying problems faced by the banks have not gone away.