Editor’s Letter – September 2015

Issue 107

Originally published in the September 2015 issue

China first introduced short selling in 2010, and made it easier in April 2015, by increasing the short-able universe to 1,100 stocks from 900, and facilitating stock lending by fund managers. This was part of Premier Xi Jinping’s wide ranging programme of liberalization, encompassing the currency, the Shanghai-HK Connect, mutual fund recognition, bank lending, state-owned enterprises and much more. But since July 2015 China has restricted short selling, and even normal selling of stocks. A minimum holding period for shorts effectively bans intraday short selling. The most draconian measure is to forbid sales for six months by owners of above 5% of a company. China’s regulator, the China Securities Regulatory Commission (CSRC) has also targeted specific investors, freezing some accounts and threatening “malicious” short sellers with prosecution. Equity futures markets, which were also introduced in 2010, have not emerged unscathed: the China Financial Futures Exchange (CFFEX) has increased transaction fees 100 fold for intraday trading, ramped up margin rates, and set extremely low position size limits. Meanwhile certain investors have been outright prohibited from short selling. Predictably, volumes on the CFFEX have collapsed.

None of this has halted, let alone reversed, the slide in richly valued mainland-China stocks. The futility of these measures matches the historical experience of short-selling bans, since the 1930s in the United States. Short-selling bans not only fail to achieve their intended aims, they also have adverse impacts on all market participants: reducing liquidity and increasing volatility. Wider bid-offer spreads impose extra transactions costs on all investors. In particular, when market makers are included in bans, options market liquidity evaporates as market makers cannot hedge their positions.

Short-selling bans can also starve companies of capital. When conventional corporate credit markets dry up, convertibles can be the only way for some companies to raise capital, but subscribers to new issues maybe scarce if they cannot short associated stock to hedge risk.

The benefits of short selling have been widely acknowledged over the past few decades. Numerous studies by universities (such as EDHEC Risk Institute), central banks (including the Federal Reserve Bank of New York) and regulators (including China’s CSRC!) agree that short selling is beneficial. Indeed in April 2015 the CSRC reportedly stated shorting “is a mature mechanism used in overseas markets, it helps moderate volatility and help with price discovery and hedging against risk.” Faster dissemination of information is a key benefit, contributing to price discovery and market efficiency. This also helps passive long-only index investors, who are less likely to overpay for stocks. They can also enhance their income through lending securities. China’s measures look like a backward step, which we would hope proves to be only an ephemeral aberration in China’s long march towards liberalizing and opening up its economy and capital markets.