Short sellers need not fear transparency
Don’t sell market transparency short
Short selling — selling borrowed shares in the hopes of profiting from a price decline — is good. It draws attention to overextended stocks, aids price discovery, and sniffs out the odd fraud. Short selling has gotten harder since the financial crisis, and it should be encouraged where possible.
The Securities and Exchange Commission wants to make short selling more transparent. It is proposing that securities lenders regularly disclose what securities they lend and what they charge borrowers. Lenders (eg big asset managers and investment banks) are understandably annoyed. The new rule would mean more paperwork for them. But some borrowers (eg hedge funds) are annoyed too, which took us by surprise. Don’t they stand to gain? More transparency ought to mean lower borrowing costs.
The SEC is hoping extra disclosure will eliminate information asymmetries in the $1.5tn securities-lending market. As it stands, securities lenders and big broker-dealers have good insight into which shares are in demand, and therefore good insight into the short side of the market. Everyone else has to settle for data that is patchy and expensive.
The proposed SEC rule would ask securities lenders to report all their activity to Finra, finance’s self-regulatory body, within 15 minutes. Finra would then publish the granular but anonymised data with a delay. That would spell a big departure from the current reporting regime, in which not-very-granular data is published just twice a month, when it is already stale.
But the Managed Funds Association, a Washington-based lobbying group representing hedge funds, thinks the rule is “misguided”. It has two big gripes. First, the rule lumps together data about what funds pay their brokers to borrow shares (called the “retail” side of the market) with what those brokers pay big shareholders to borrow shares to lend in turn (“wholesale”). It says that retail pricing is governed by complex prime-broker relationships involving more than just securities lending, so that data is not informative and could be deceptive.
Second, the MFA thinks the rule exposes short sellers to the risk others will suss out their trading strategies. The result it fears is front-running or GameStop-style short squeezes. To make the data harder to game, the MFA would prefer only daily aggregated data on wholesale volumes and prices be disclosed, not data from both sides of the market several times an hour, as proposed.
The MFA could be right that segmenting retail from wholesale short data makes sense. But we are sceptical about the worry that more reporting would discourage short selling. As James Angel of Georgetown University explained to us:
What a lot of people don’t really appreciate is that the borrowing actually occurs on the settlement date [two days after the trade]. The short seller has to find someone willing to lend the shares [later], do the trade, then go back [at settlement] and say, hey, remember me? But at that point the trade has already been done, so there is no new information as to someone being short. Selling information already became available.
But there is a grain of plausibility [to the hedge funds’ worries]. If someone wants to put on a big position they can’t do it all at once. There are situations where it takes more than two days to put on a short position, so there could be information there.
So it seems unlikely that the broad swath of short sellers could be sniffed out by other traders looking to squeeze them. One notable short seller, Arnaud Vagner of Iceberg Research, told us this on Monday:
I am very much in favour of more short interest data [though] for granular transparency requirements, they should match long holding requirements. No reason for short sellers to be subject to more demanding requirements.
The problem with GameStop [was] that hedge funds should not have taken a position with so high short interest. The data were stale but short interest would have been very high anyway.
Updated market short interest data would not increase the risk of a short squeeze.
Muddy Waters Research’s Carson Block told the FT something similar previously:
The new reporting requirements would benefit all market participants by “making it easier to gauge scepticism about a company and its propensity to be driven upward in a short squeeze, GameStop being the modern day poster child”.
Trading tactics may have to adjust, but in general having more knowledge is bound to benefit short sellers even as it benefits the market. But for some hedge funds, who in the post-GameStop era seem to prefer a bit more quietude, perhaps less public knowledge is the point.