Regulation of Short Selling

In more mature stock markets, short selling is usually permitted, but it could be prohibited during a financial crisis (like the one in 2008). Recently the Technical Committee of IOSCO released the Consultation Paper on Regulation of Short Selling.

The Technical Committee believes that short sellling have important functions such as providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities. However, there is also a general concern that during extreme market conditions, certain types of short selling may contribute to disorderly markets.

Short selling is typically defined based on two factors: (i) a sale of stock that (ii) the seller does not own at the point of sale. Some jurisdictions (like Hong Kong) do not directly define short selling but prohibiting "naked" short selling.

The Consultation Paper has developed the following high level principles for effective regulation of short selling, briefly highlighted below:

Principle 1 - Short selling should be subject to appropriate controls to reduce or minimize the potential risks that could affect the orderly and efficient functioning and stability of financial markets.

• The Technical Committee recommends the imposition of a strict settlement (e.g. compulsory buy-in) of failed trades. Having a short settlement cycle (no later than T+3) can help to reinforce settlement discipline. Other measures such as price restriction rules (e.g. uptick rule), "locate" requirement (e.g. stock borrowing) and "flagging" of short sales are also useful for preventing abusive short selling.

Principe 2 - Short selling should be subject to a reporting regime that provides timely information to the market or to market authorities.

• There are two models that are commonly used by various markets for short selling reporting: (i) flagging of short sales and (ii) short positions reporting. While transparency of short selling information should be promoted, the Technical Committee recognizes that such information may mislead the market and subject short sellers to potential short squeeze.

Principle 3 - Short selling should be subject to an effective compliance and enforcement system.

• The Technical Committee encourages market authorities to consider extending their power to require information parties suspected of breach, beyond the scope of licensed or registered persons if they lack such power. Market authorities should also review whether their cross-border information sharing arrangements are sufficient to facilitate cross-border investigation.

Principle 4 - Short selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development.

• Legitimate short selling should not be prohibited. Activities falling under category may include bona fide hedging, market making and arbitrage activities. Short selling regulation should consider building in flexibility. For example, failed trades arising from market making activities are not subject to strict settlement requirements but rather allow more time to close out the positions.

Based on my observations, Hong Kong is to a large extent fulfilling the above four principles for regulation of short selling.