The Mayfair mafia who helped to bring down a banking giant

Hedge funds based in the heart of London have been blamed for HBOS's demise. But who are they? Nick Clark explains

HBOS has suffered staggering losses in its share price this year, as fearful investors reacted to the market turmoil by selling off their holdings in the banks. These losses have been exacerbated by the controversial practice of "shorting" the stock, predominantly carried out by wealthy hedge funds traders.

The controversial trading strategy has come under attack this year, with politicians, investors and regulators pushing for more transparency over the practice and higher controls to protect vulnerable stocks. Some have demanded an outright ban in some cases.

Investors buy shares to profit from company's growth, which leads to a rise in its share price. Short sellers are betting the opposite way; their profits soar when a company's value slumps. Short sellers borrow shares from a long-term shareholder – normally a pension fund or insurance group – for a fee and immediately sell it into the open market. Should the price decline before the agreed time to return the shares, the trader pockets the difference.

The use of the strategy has soared. Earlier this year there was an estimated $1.4 trillion of equities on loan, although not all for short selling.

The Financial Services Authority, the UK regulator responsible for overseeing the markets, acknowledges the point made by the International Securities Lending Association, which said the strategy is, and should remain, legal.

In normal markets, shorting allows for the better pricing of assets. Critics have pointed out, however, that these are not normal markets, and retail banks are not ordinary stocks. Collapses in confidence lead to the mass sell-off of shares, and shorting only helps drive a tottering institution closer to the wall. The short sellers – who have no interest in its welfare– make more as a stock falls further, and the collapse becomes a self-fulfilling prophecy. In banking stocks, where savings are at stake, the results could cause mass panic.

As HBOS staggered earlier this week, Vince Cable, the Liberal Democrats' Treasury spokesman, said shorting bank stocks should be banned, as it pits hedge funds against the taxpayer. "The FSA has intervened before to stop hedge funds wrecking rights issues for the banks. They must step in now."

Yet, with the financial markets in an increasingly volatile state, and any bad news sending indices diving, the practice is unlikely to become less popular. One trader said last week: "I can't see any reason for not staying short."

The Securities and Exchange Commission imposed restrictions yesterday on short selling in the US. In the UK, the Chancellor has set up a working group but has left the job of overseeing short selling to the FSA.