Ben Cook explains why the market needs restrictions on short selling ... for now.

The FSA has launched measures to restrict the short selling of stocks in publicly quoted financial companies amid fears that the shares of major institutions – including several leading insurance companies – could plummet as a result of the practice.

Short selling is when an investor borrows shares from another investor with a view to selling them. The investor sells the borrowed shares in the hope that the price will fall so he can buy back the shares at a reduced price. He then returns them to the original owner and pockets the difference.

Short selling was partly to blame for the dramatic fall in HBOS’s shares last week, which led to the bank being taken over by Lloyds TSB. The reason for the fall was that if many traders are trying to sell the same type of share, the price of that share would drop. Hence the FSA’s decision last week to prohibit “the active creation or increase of net short positions in publicly quoted financial companies”.

The FSA rules on short selling also state that there should be a “daily disclosure of all net short positions in excess of 0.25% of the ordinary share capital of the relevant companies held at market close on the previous day”.

Basically, the FSA introduced these measures because it didn’t want other major financial companies – which include Admiral, Aviva, Brit, Highway, Novae and RSA – getting into trouble as HBOS did. However, it should be noted that short selling has not been permanently banned. The FSA’s restrictions will remain in force until 16 January 2009, subject to a review that will take place towards the end of next month.

Hector Sants, chief executive of the FSA, made it clear that short selling was, by and large, a perfectly acceptable practice. He said: “While we still regard short selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets – as a result, we have taken this action to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector.”

Ben Cook is a freelance journalist.