Sold short?

The Financial Services Authority has announced a clampdown on the short selling of stocks in publicly quoted financial companies amid fears that major financial institutions – including several leading insurance companies – could see their shares plummet as a result of the practice. By way of a brief explanation, 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 then fall so that they can buy the shares back at a reduced price before returning them to the original owner and pocketing the difference.

Short selling is 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 being that if many traders are trying to sell the same type of share, the price of that share will 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 new FSA rules on short selling also state that there should be a “daily disclosure of all net short positions in excess of 0.25 per cent 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 PLCs – 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 new restrictions will only 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.”