HEDGE FUNDS

Coming up short

In the past two months, regulators on both sides of the Atlantic have intervened in the epic struggle between financial companies and the hedge funds that are short-selling their shares. The U.S. Securities and Exchange Commission (SEC) and the U.K. Financial Services Authority (FSA) each scrapped their usual pattern of industry consultation and put out new restrictions so quickly that they were still tinkering with the details as the rules came into effect.

Desperate to prevent more collapses in the financial sector, the SEC on Tuesday extended its ban on “naked shorting” of 17 investment banks, and of Fannie Mae and Freddie Mac, the two mortgage giants. Some argue that such trades, in which investors sell shares they do not yet possess, make it easier to manipulate prices. The SEC has also reportedly issued over 50 subpoenas to banks and hedge funds as part of its investigation into possible abusive trading of shares of Bear Stearns and Lehman Brothers.

The SEC’s moves deserve scrutiny. Investment banks must have a dizzying influence over the regulator to win special protection from short-selling, particularly as they act as prime brokers for almost all short-sellers. There is as yet no evidence that market abuse has driven down financial firms’ share prices – and plenty that their toxic balance sheets and credibility have. Indeed, the SEC’s initiatives are asymmetric. It has not investigated whether bullish investors and executives talked bank share prices up in the good times. Moreover, the SEC’s rule affects only Fannie Mae, Freddie Mac and 17 banks. If the practice is really such a problem, what about the 8,500 other banks?

London’s financial services regulator has as yet failed to provide evidence to justify its decision to tighten the disclosure rules on short-selling of some bank shares. The FSA’s June rule sought to protect companies carrying out rights issues by forcing short-sellers to reveal positions above 0.25% of outstanding shares. But the one-off disclosures do not actually limit shorting and simply supply an unilluminating snapshot of who holds what.

Both the SEC’s and FSA’s rules smack of scapegoating. It is easier to point the finger at hedge funds than address systemic problems. But regulators should not forget their history. Outside short-sellers were blamed for the 1929 crash but the Pecora Commission investigation revealed that the main beneficiaries of the practice were banking insiders such as Albert Wiggin, the Chase president. More recently, Biovail, the Canadian drugs maker, complained vociferously about shorting but has now been sued by the SEC for alleged accounting fraud. In an era of global computerized markets, new rules on shorting may indeed be necessary. But the current regulations seem more like poorly conceived window dressing.