The Gateway to Algorithmic and Automated Trading

Short Selling and Risky Margin

Published in Automated Trader Magazine Issue 11 Q4 2008

Since Automated Trader’s Q3 issue hit your desktops, we have been living in interesting times. In our conversations with you in the last few weeks before going to press, two things have been top of your agendas:

  • The short selling ban on financial stocks
  • The security of margin deposits in the event of a clearer’s failure.

This issue’s First People feature showcases some of these conversations.

The short selling ban

Miles Kumaresan, Head of Algorithmic Trading, TransMarket Group

It is a nuisance. It is also a false intervention, because the markets are not going down simply because of short sellers - they are going down because the fundamentals are poor. All the ban is doing is putting a small temporary brake on this situation; rather like trying to close the gate on a huge dam.

Miles Kumaresan, Head of Algorithmic Trading, TransMarket Group
Miles Kumaresan

I think the people who will be most affected will be the stat arb players who have built baskets and carefully constructed portfolios for synthetic pairs or similar strategies. Those baskets/portfolios will be temporarily disrupted and the optimisation and modelling processes for them will have to be rerun. Furthermore, if you cannot short sell these financial stocks, then that puts considerable constraints on the optimisation. However, whatever return is lost due to short selling restrictions is more than handsomely made up for by the prevailing market volatility.

By contrast, the effect on algorithmic execution should be relatively small; after all the majority of stocks are unaffected by the ban. There are some stats that will change and there may be some liquidity pattern changes due to the lack of short selling, so analytics such as fill probabilities will be affected. However, not many execution algorithms use particularly sophisticated fill probabilities or liquidity measures, so the impact may not be very great. Such effects as there are will also work through the system very quickly.

Clive Williams, Head of European Equity Trading, T. Rowe Price London
Clive Williams

Clive Williams, Head of European Equity Trading, T. Rowe Price London

At the moment we don't see the ban on short selling as making it much harder for us to do our job in terms of finding sufficient liquidity from sellers. However, if the ban extends right through into next year one can't be completely sure what effect it will have.

Nevertheless, coupled with the extraordinary market conditions, the ban is certainly having an effect on execution algorithms. A lot of the assumptions built into algorithms were well off the mark for the current environment, which meant they were going rather haywire last Friday [19th September], so we were trading very carefully.

Apart from the ban, another thing that will affect the viability of short selling as a strategy in the future is stock availability. Some long only institutions have fuelled hedge fund short selling by lending out their stock for minimal fees, perhaps without realising the consequences. Traditionally, index funds have been among the biggest lenders of stock and, while they may not change, at the margin people will be looking more closely at their stock lending practices and the amount of money they actually get from it. As and when the market settles down, stock lending inventory is likely to be smaller and certainly a great deal more expensive. There's a good chance that a lot of firms will pull out of stock lending altogether.

Incidentally, I think people using execution algorithms may have found they have some unwitting exposure to Lehman in terms of outstanding trades. At the time of the trade they won't have known who was on the other side, but they will now. Unravelling all this should certainly make for some pretty good overtime for the back office...

Dennis Lohfert, Director of Trading, Ion Asset Architecture

The restrictions have been poorly conceived, badly executed and inconsistently applied.

The ability to short-sell assets perceived as overvalued is critical to maintaining the informational efficiency of markets (ie prices reflect all available information).

Difficulty in short selling may have contributed to the tech bubble in the late 90s (cf. low free floats and difficulty in shorting), and the recent "bubble" in the Chinese market. Look at the loss of wealth that resulted from those episodes! Ironically, a week after the US restricts short selling, China passes legislation allowing it for the first time because they hope that it'll re-vitalize their equity market. Short selling is an integral part of modern financial markets, period.

Restrictions on the short sales of stocks result in the underpricing of risk (i.e. they lower the cost of equity capital), which encourages "bad" risk taking and creates moral hazard - precisely what regulators should be seeking to avoid, and something that seems to enjoy widespread public support in both the US and UK!

The short selling restrictions are adversely impacting the legitimate, long-established businesses of many traders, such as equity and ETF arbitrageurs. Thus the regulations arguably represent a transfer of wealth from those people to the shareholders of investment banks and other financial institutions that are, to the largest extent, responsible for the current crisis! Again, we're rewarding those who should be punished.

John Reeve, Head of Quantitative Trading, BlackCat Capital
John Reeve

John Reeve, Head of Quantitative Trading, BlackCat Capital

It is vital to draw a clear distinction between regulation, which is good and necessary for the orderly functioning of markets, and market manipulation which is damaging and usually illegal. An attempt to artificially raise the price of a select group of stocks by banning short-selling is clearly an act of market manipulation and one that appears to be politically motivated and founded on misconceptions.

History shows that such manipulation has a propensity to produce the opposite effect to that which was originally envisaged. At a time when the financial system is already under great stress, the ban has caused additional disruption to normal business activities and immediately caused the share price of a broader range of financial stocks to fall.

The long term effects remain to be seen, however, the financial regulators have changed the rules, mid-game with seemingly little consideration for the broader effects and with no consultation. They have appeared to be dangerously out of touch with the complexities of modern financial markets and their credibility within the industry must have suffered along with the confidence that investors place in the markets.

After years of failing to tackle the obvious and growing credit bubble, the regulators have finally acted but have done the wrong thing. This bodes ill for the future, raising the likelihood of new but poorly conceived and probably politically-inspired regulation. A question that remains unanswered is why the world's regulators failed to exercise their existing and considerable powers to rein in irresponsible lending before it grew to crisis proportions?

We will follow the progress of any legal actions that arise from the short-sale ban with interest…

David M. Aferiat, Managing Partner, Trade Ideas LLC

Let's remember the service short sellers provide: they are the canaries in the coal mine. Their job is the market equivalent of free speech that permits a contrarian view to management's decisions. Short sellers are a trip wire and when part of a regular functioning market, warn of possible shenanigans - or criminal activity. Under these circumstances we've effectively, as Fred Wilson, an American venture capitalist puts it, "shot the messenger."

Where's my margin?

Nick Collison, Managing Director, Saxon Financials
Nick Collison

Nick Collison, Managing Director, Saxon Financials

There have been instances in the past of clearers failing, but these have typically been fairly small scale; certainly nothing of the magnitude we have come close to witnessing in recent weeks. In a sense the boot has been on the other foot of late; typically clearers worry about their clients' solvency - not the other way round.

The interesting thing is that when these situations arise the whole topic of segregated accounts suddenly reappears. Very few traders really understand what segregation actually means and that in practical terms it doesn't really exist. That is why our biggest concern recently has been of a major client collapsing and possibly taking the clearer with them, because the clearer's parent bank (if it had one) might withdraw support when most needed.

In the past, the general perception was that the clearer's parent would stand good, but since the collapse of Lehman everybody has had to rethink that stance.

Dmitry Bourtov, Fund Manager, Solaris Market Neutral Fund
Dmitry Bourtov

Dmitry Bourtov, Fund Manager, Solaris Market Neutral Fund

The margin question hasn't really affected us, as virtually all our positions are on US markets. Margin associated with those positions must by US law be held in segregated accounts by the FCM. This is reflected in the way accounts are handled if you deal through the same clearer for both US and other markets. If for example you trade both CME and LIFFE/Connect products denominated in USD, you will have two separate accounts. One will be in segregated dollars and other in non-segregated dollars. Each account will have its own margin requirements, balance and NLV.

However, we have noticed that some US clearers are becoming very aware of clients' concerns regarding security of non-US margin and are putting in place structures to ring-fence client margin to alleviate these concerns.

Badrinath Krishna, Head of Solutions Group, Financial Services (Retail & Corporate Banking), HCL Technologies Limited

My view is the margin has not been lent to the clearer but merely placed with him as a security deposit. As such, all margin depositors would have the most senior claims on their funds, and should get their money back in the normal course of liquidation proceedings. The only impact would be the delay involved.

Simon Brown, Managing Director, Cambridge Quants
Simon Brown

Simon Brown, Managing Director, Cambridge Quants

This issue will put the seeds of doubt into many non-clearing member firms, even if they have segregated accounts.

I suspect that many non-clearing members will now move their clearing to 'government backed' Fortis, so that the answer to the question becomes academic for them when their traders and shareholders ask the same question about margin security.

Miles Davis, Senior Manager, SMART UK
Miles Davis

Miles Davis, Senior Manager, SMART UK

Margin security is just one of several areas that will see considerable regulatory focus in the future. A key element of this focus will be improved transparency; it looks more than possible that regulators will be looking to come up with some form of score card for this that clearers will have to adhere to.

On the flip side, it is obviously a subject that trading organisations, such as hedge funds and proprietary trading groups, will have to think about much more closely in the future. Operational risk management, which until recently has been seen as a cost of doing business, will be moving to centre stage.

The short selling restrictions have been massive news for auto/algo traders, so Automated Trader would like your views on this (well, the printable ones anyway) at http://www.automatedtrader.net/announcements-1748.xhtm

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