Proposed law sells HK short
7 March 2010
Poll: Short position disclosure
Please log in to see how you voted, if you did.
Poll closed: 18:00:00 19-Mar-2010
Imagine, if you will, a consultation paper on road speed limits, in which the Government proposes introducing a 50km/h speed limit, and after collecting responses, they decide that because traffic moves slower here, they will introduce a 4km/h speed limit instead, 10 times lower than other countries decide to do at the same time.
That, in essence, is what Hong Kong's Securities and Futures Commission has just decided to do with short-position disclosures to the regulator. The change needs subsidiary legislation which is subject to Legislative Council negative vetting, so there is still time to stop this madness. It puts HK way out of line with international rules, including those announced by Europe the same day, as we explain below. If we don't stop this then for institutional investors, it will impose a high administrative burden for no public benefit, and many private investors or institutions selling dual-listed stocks overseas will likely just ignore it.
Don't get us wrong: Webb-site has always advocated transparency in every aspect of governance, but only where it results in meaningful disclosure and the benefit to the public interest justifies the costs. We need well-designed regulation, not just regulation for the sake of it.
If you understand short selling in HK then skip this section.
A "short sale" is when a person sells shares he has borrowed, betting that the share price will go down rather than up, creating a "short position". If he can buy them back at a lower price, then he makes a profit. If he has to buy them back at a higher price, he makes a loss. All short sales are tagged as such, and the aggregate amount of short sales in each stock is disclosed twice daily by HKEx. There is no disclosure when the short position is closed with a purchase, so the total short interest is not known.
Not all short sellers are betting against the market direction. Often, the short-seller will be making a relative-value bet, by buying something else as a hedge. For example, in a "pair trade", he might buy the shares of a listed company and short the shares of its listed subsidiary, betting that one will out-perform the other, or in a "merger arbitrage" trade during a takeover offer, he might buy the shares of the target and sell short the shares of the offeror, or vice versa. These are known as "market neutral" positions.
Since all short sales must result in delivery of stock (or compulsory buy-in) on settlement day, the aggregate of all long minus short interests in a company must be 100% at all times. If there are 120% long positions, then there are 20% short. There is no theoretical limit to how many times borrowed shares can be resold - shares don't have a label on them saying "I am borrowed". So in theory (but seldom if ever in practice), the long interests could be 300% and the short interests would then be 200%. The net total is still 100%.
Under archaic SEHK Rules, not all stocks can be sold short. They publish a list of Designated Securities Eligible for Short Selling (DSESS), currently including 520 stocks. This includes 7 stocks in the ill-fated Nasdaq pilot program, 6 Real-Estate Investment Trusts and 52 Exchange-Traded Funds (ETFs), leaving about 455 ordinary shares. This restrictive list is probably honoured in the breach by borrowing the stock offshore and not tagging the sale as short. As long as you deliver, nobody here will know. One asset manager told us the other day how he was able to borrow shares in a stock he regarded as overvalued (all his HK orders are placed through a New York head office) before realising that the stock was not on the DSESS list, so he didn't sell.
SFC research and consultation
In a research paper published on 23-Oct-08, the SFC found that short selling in HK from 22-Sep-08 to 22-Oct-08 (during the crisis) accounted for only 7.6% of market turnover, compared to 7.4% in the second quarter and 8.5% from 1-Jul-08 to 19-Sep-08. The SFC estimated that the aggregate short position was about 1% of market capitalisation, well below that of New York (4.7%) and about the same as Australia (1.0%).
In a further research paper on 17-Apr-09, on the liquidity effect of short-selling, the SFC concluded that:
"trading volume rose as short selling increased. Short selling improves market efficiency and increases turnover, be it directly or indirectly. As short selling helps price discovery, it encourages trading in the overall market...Short-selling activity helped narrow bid-ask spreads."
Given all those benefits, you might wonder why short selling isn't allowed on all stocks. So do we. A free-market approach would allow it.
On 31-Jul-09, the SFC issued a consultation paper on increasing transparency of short positions. It mentioned that during the financial crisis, the UK had introduced a temporary requirement for public disclosure of short positions of 0.25% (in financial stocks and companies conducting rights issues) and was consulting on a permanent one with a 0.5% trigger. In the US, there was an emergency requirement for weekly disclosure of 0.25% short positions, applicable only to discretionary managers holding more than US$100m of certain classes of equities, which expired on 1-Aug-09.
As the SFC noted in its consultation paper (but failed to follow):
"A threshold that is too low would be overly burdensome and may render the threshold meaningless."
Given the relatively low levels of short positions in HK, the consultation paper was a solution in search of a problem which doesn't exist. On p13, the SFC looked at stock loan estimates as a proxy for short positions (because you can't short shares without borrowing them to deliver). Looking at about 320 HK stocks, it found that in late Feb-2009, about half of them had total stock loans below 0.50% of market value, so no single holder could have been short more than 0.50%. In other words, in half the cases, the long positions were between 100.0% and 100.5%, and the short positions were between 0% and 0.5%. Even if you only count the free float of 25% as long, you have long positions outweighing short positions by 51 to 1. How is that a problem for market stability? Furthermore, About 36% of the 320 stocks had total short positions less than 0.25%. The SFC stated that:
"if we adopt a threshold approach to capture significant short positions, the threshold level should not be higher than 0.25% of the issued share capital which is the level adopted currently in London and New York."
The giant flaw in the SFC's reasoning is that they decided that if short positions were not significant relative to other markets (let alone relative to long positions), then they should make them significant by adopting lower disclosure thresholds. That is rather like saying that, if speeding is not a problem in HK, then we should make it a problem by having lower speed limits than other territories.
The gap in HK law
Although we oppose the new requirements, there is a problem with the law, and this is where the SFC and Government should focus its efforts.
The Securities and Futures Ordinance requires shareholders to publicly disclose long interests of 5% or more (i.e. 250 times larger than the proposed private short position threshold), but the only statutory requirement for short positions is that, if someone has a long position over 5%, then they must disclose any short position over 1% in the same stock. This would almost never happen, because anyone who wanted a long position would not want a short position, and vice versa. It is cheaper to buy 4% than to buy 5% and short 1%. So short disclosures are only made by a few quirky participants such as operators of stock lending pools. Because of this omission in the law, in a stock with a 30% free float, you could have a short position of 6% of the company or 20% of the float, and you would not have to disclose it publicly.
Directors of the issuer must disclose all positions however small.
The obvious question here is this: if a long position is only significant enough to be publicly disclosed at the 5% threshold, then why is a short position significant, even to the regulator, at the 0.02% threshold? Why not have symmetric, public disclosure obligations for long and short positions, including derivatives, at the same threshold, whether at 5% (the HK and US standard) or 3% (the UK standard)?
The SFC is not proposing any public disclosure by holders, only private filing to the SFC, which will disclose aggregated data without names. This opens the possibility of the SFC being privy to price-sensitive information on individual large short interests, where the short shareholder itself might also be listed, and the consequent risk of illegal leakage. The public might be told that there is a 10% short interest in a stock, but they wouldn't know whether that was 50 holders averaging 0.2% each, or 1 big player who is short 10%. Inevitably investors would speculate and try to find out whether there was a single big player and who the player was. So the disclosure of aggregated data would put the spotlight on the SFC.
We emphasise that the SFC is pretty good at maintaining its statutory secrecy, but that's partly because the public doesn't know anything about what the SFC knows on pending takeovers or secret investigations, so there is no pressure for leaks. That would not be the same if there are aggregate public disclosures derived from SFC filings. These would be the "known unknowns" rather than the "unknown unknowns", in Rumsfeld-speak. If you tell us half of the data, we'll want the rest.
The regulatory principles
The global regulatory scrutiny of short-selling is apparently aimed at stocks allegedly being "pushed down" by short sellers, which regulators and politicians say "causes panic" and makes the firms "more likely to fail". But in an efficient market, if the stock was not over-priced then why wouldn't buyers come in to meet short sellers? If the stock is a bank, and investors have confidence in it, they will buy. Buyers have unlimited upside and limited downside. For short-sellers, it's the opposite - they have unlimited downside and limited upside, because the stock can only go to zero (on bankruptcy), not negative. If anyone has to be certain about their analysis, it is short-sellers. They take more risk.
The global regulators are confusing cause and effect - banks collapsed during the crisis because of over-leverage and reckless lending (facilitated by lax regulation) and the consequent busting of the property bubble, not because of short-sellers. After short-selling of financial stocks was briefly banned in the USA and UK, banks continued to collapse. Don't shoot the messenger - the global markets' price discovery mechanisms were working.
As regards the circulation of false information about a listed company, whether positive or negative, there are laws against that, and those laws operate independently of disclosure of short or long positions. There are just as many incentives to circulate false positive news about a profit boost or a takeover (or in HK, some Chinese/Mongolian mining injection), and the upside on that is greater than false negative news.
Despite the overwhelming lack of evidence that short-selling causes companies to fail, regulators, including those in Europe, seem hell-bent on imposing far more stringent disclosure requirements on short positions than they do on long positions.
There is no other aspect of the HK law which requires shareholders to make private disclosure to the regulator but not make public disclosure. We do not, for example, have to tell the SFC when we own 0.02% of a company. Indeed, almost all of your editor's holdings exceed 0.02% and several are disclosed above 5%. He has never had a short position, but may in future. Why introduce a law on private disclosure of short positions? Why not just decide on the public disclosure requirements for both long and short positions (5%, or lower) and leave it at that?
The SFC's conclusion
The SFC's conclusion paper issued on 2-Mar-2010 is draconian. The SFC will require holders of short positions exceeding just 0.02% (that is, 1/5000th) of a company's issued shares, and any short position which exceeds HK$30m, to report their position privately to the SFC weekly. The $30m threshold only kicks in above $150bn, so that only relates to 19 companies (as of Friday). In the largest case, $30m of China Mobile Ltd (0941) is just 0.002%. To put this in sporting terms, it is equivalent to a 2 millimetre bump in a 100 metre-long soccer pitch. It may be significant to an ant, but not to a soccer player.
The reporting requirement will apply to stocks in the Hang Seng Index (43 stocks) and the H-share Index (40 stocks, of which several are in the HSI) and "other financial stocks" which are not in the index. They haven't defined what they mean by "other financial stocks", but it is safe to assume it includes (but is not limited to) any company which derives a majority of its activity from banking, and probably insurance underwriting. Does it include listed stockbrokers and asset management firms? Insurance brokers? Only time will tell.
The criteria for inclusion in the DSESS list include companies with a market cap (at the time of admission) of at least HK$1bn and an aggregate 12-months turnover of at least 40% of market capitalisation. Therefore, for the smallest stocks, the disclosure threshold of a 0.02% short interest would amount to just HK$200k (US$26k) - not even enough to buy a board lot of Rusal with the proceeds.
The warped logic of the SFC is reflected in paragraph 30 of the conclusions:
"While 0.25% is used in triggering the short position reporting requirement in several overseas jurisdictions...we note that not many reporting obligation is triggered (sic) each day...This implies that if a similar trigger level is used in Hong Kong, only very large short positions in the shares of very few companies might exceed the threshold..."
So they appear to define "very large" based on the frequency or size relative to other short positions, rather than relative to market cap. The goal seems to be to meet some quota of disclosures, rather than to disclose what is meaningful. And there's more:
"0.02% of the issued share capital of a large-cap company may have a very large value (e.g. 0.02% of the issued share capital of the top three constituent stocks of the Hang Seng Index is about HK$300m each)."
So what? This is just a banal truism, rather like saying 0.02% of Li Ka Shing's net worth is a lot of money. Would it be news if his net worth had changed by that amount? Of course not. Would it be at all meaningful if the long position of say, Fidelity in HSBC had changed by 0.02%?
At the same time as setting such a low disclosure threshold, the SFC decided to exclude derivative interests, such as put options, short futures contracts, or contracts for differences. That is not an acceptable compromise, as it is likely to shift activity from the underlying stock to the derivative market, particularly contracts for differences.
Ironically, just a few hours after the SFC announced its decision on 2-Mar-2010, the Committee of European Securities Regulators (CESR), which includes representatives of the regulator in each EU member state, also announced its recommendations and issued a report to the European Commission to introduce a pan-European short-selling disclosure regime. The recommendation is that interests of 0.2% (10 times the proposed HK level) would trigger private disclosure to the regulator, while short interests of 0.5% would require public disclosure. Market-makers would be exempt, but all derivative interests would be included.
Apart from leaving HK with much stricter filing requirements, it also results in likely partial disclosure for dual-listed stocks. For example, do you really think that a firm based in the UK with no HK presence, which has short-sold 0.02% of Standard Chartered or HSBC shares in London, is going to report their short interest to the HK regulator? Highly unlikely - they may not even be aware of the obligation, much less comply with it.
The proposed law will incentivise short sellers to use London rather than HK. It puts HK at a competitive disadvantage. Put simply, it sells HK short.
Where's the external force?
After observing regulatory developments here for over 18 years (11 on this site), we can't help but notice that consultation exercises usually conclude in either abandoning the proposed reforms, or doing something no stricter than was proposed. Like Newton's first law of motion, a regulatory body moves at constant velocity unless some external force acts upon it.
This time, the SFC's "conclusion" is 12.5 times stricter than what their consultation paper suggested. It seems likely to us that the Government, through the Financial Services and Treasury Bureau, and/or through the Non-executive Directors who form a majority on the Commission, has pushed them to go far further than they had proposed.
The Legislative Council should push back.
- We call on the SFC to look to Europe and withdraw or amend the proposals. The requirements should be no more stringent than Europe's, if and when implemented.
- We call on Government to legislate a public disclosure threshold for short positions, including derivative interests, at the same level as long positions (currently 5%)
While they are at it, the should amend the SFO to remove Saturday from the definition of business days, which is largely honoured in the breach when it comes to calculating 3-day deadlines for disclosures of interests. Most of HK is now on a 5-day week, and the Exchange hasn't opened on Saturdays in our living memory, but the law seems to think we will all be busy filing disclosures on Saturdays.
Your name will not be disclosed, but the aggregate results will be sent to Legislators, the Government and the SFC.
© Webb-site.com, 2010