A legitimate practice that could cause market chaos

Short selling is an investment practice designed to profit from a company expected to fall in value, by selling shares an investor doesn't own in the hope of buying them back more cheaply once the price has fallen.

In practice, an investor borrows stock in the company – for a fee – from a long-term holder of the shares, typically a pension fund or an insurance company. The stock is sold into the market at once and then bought back at a predetermined time – known as "covering the short" – to be returned to the lender. If the shares have fallen in value by more than the lending fee, the investor makes a profit.

Short sellers include traders at investment banks, brokers and hedge funds. They place orders through an internal stock lending desk, if at a bank, or to a prime broker such as Goldman Sachs or Morgan Stanley, if at a hedge fund.

Borrowing shares in FTSE 100 companies usually costs around 0.8 per cent of the value borrowed. Borrowing more illiquid stocks may require the bank's stock lending desk to phone round its network of contacts and to negotiate a fee for the deal.

There is no central exchange, so all prices have to be negotiated individually, with the cost of borrowing particularly illiquid stocks rising to as much as 50 basis points. The borrower normally has to put up collateral – either cash or assets such as shares or bonds – worth 105 per cent of the stock borrowed.

Investors and regulators alike, including the Financial Services Authority, accept that short selling is a legitimate investment strategy, but question-marks remain. In particular, are long-term holders of shares jeopardising their own interests by lending out stock to investors who will profit from a fall in its value, particularly during volatile periods for markets, such as now, when even minor worries about a company can precipitate collapses that may take some years to put right?

The UK Shareholders' Association (UKSA) certainly has concerns. A spokesman said: "The problem is that at a time like this, speculation can drive shorters to undermine a fundamentally strong stock, and the market becomes so chaotic that it is impossible to trade effectively."

Companies involved in rights issues, the focus of the FSA, can be especially vulnerable. Short selling before a rights issue "causes particular difficulties", the UKSA spokesman said. However, Andrew Baker, deputy chief executive of the Alternative Investment Management Association, says short selling – and thus stock lending – can be a positive influence. "It adds more liquidity to the market and actually provides a more accurate valuation for the stock," he said. "The long-term investors are happy as they make some money out of shares they will hold for years and wouldn't otherwise generate. Any short-term volatility will be played out."