Short selling, the secret everyone knows about

The practice is common in the UAE and was partly blamed for the collapse of Lehman Brothers in the US last year, but is it really such a bad thing?

Short selling is illegal in the UAE, but commonly practiced.

Short selling, or speculating that the price of a stock will go down, is common in developed markets. Shorting is also in widespread use on the UAE's local markets, the Abu Dhabi Securities Exchange (ADX) and the Dubai Financial Market (DFM). But because the practice is unregulated here it is especially risky.

While many stock brokers and financial institutions say they engage in short selling, the Emirates Securities and Commodities Authority (ESCA) does not recognise the practice, so investors are unable to sue and seek damages if short-selling contracts are broken. Because of a lack of regulation, data about the number of investors selling short also goes undisclosed, putting other traders at a disadvantage. In part for these reasons, ESCA spoke out in September against short selling.

"The market wishes to confirm that all institutions that are actively involved in local financial markets are required to conduct their businesses in accordance with established regulations, and would like to make it clear that short-selling operations are inconsistent with the spirit of these regulations," ESCA said. "The market hereby urges all parties to abide with established regulatory rules and refrain from practices which are not yet codified in local markets."

In a short sale, an investor borrows a block of stocks for a set period, paying a small amount of interest for the privilege. He then immediately sells the stock and pockets the cash proceeds. If the stock's price declines, he can then use his cash to buy back the same amount of shares he borrowed, but at a lower price, pocketing the difference. But even though in theory it is frowned upon, in practice short selling occurs every day. Last week on the floor of the ADX, Eyad Hagag, a day trader, said that even a beginner could see what was happening.

"Short selling has been occurring during this time and some securities companies have been taking this opportunity," he said. Short selling is popular because of the volatility of local markets. When markets fluctuate wildly, as they have during the past year, the opportunity to profit on day-to-day price movements can be enormous. But, volatility, of course, also poses great risks for investors. "The UAE equity market has been historically one of the most volatile in the world, and almost certainly in the GCC," Eric Swats, a partner at Rasmala Investments in Dubai, said last month.

"The way the market behaves promotes this kind of activity," says Ibrahim al Sharji, an Emirati who observes stocks in Abu Dhabi. Several investors on the trading floor in Abu Dhabi said that in recent weeks individual and institutional investors were short selling before and after the announcement on November 25 that Dubai World would seek a standstill on US$26 billion (Dh95.5bn) of debt. That news sent markets across the globe downwards and led to profits for those who sold short on local markets.

Eyad Abdul Nabi, the chief operating officer at Al Ramz Securities, believes the 20 per cent drop in DFM stocks after the Dubai World announcement was mostly on account of "naked" short selling - entering into a short-selling contract without even borrowing the stock to sell. Naked shorting has been banned in most developed markets, including the US and UK, because traders can use it to manipulate stock prices downwards.

Regulation of short selling in the UAE would be a good idea, many market participants say. Mr Abdul Nabi said that if ESCA recognised the practice of short selling, this could reduce volatility and aid in the maturation of the UAE's markets. "The drop we saw [after the Dubai World announcement] could have been avoided," he said. "It was an exaggerated drop." Allowing a regulated form of short selling, he said, would increase trading volumes and bring much-needed liquidity to the market. It would also give investors a legally permissible way to hedge large exposures to individual stocks, a key component of institutions' risk-management strategies.

The UK's Financial Services Authority and the US Securities and Exchange Commission (SEC) placed a temporary short-sale ban on hundreds of stocks, as shorting was partly blamed for the demise of the investment bank Lehman Brothers last year. But is short selling such a bad thing? A Hong Kong University study of the effect of the SEC's temporary ban on short selling concluded that "curbing short selling to reduce downward price pressure could come with a cost of slower incorporation of information and lower liquidity". The study said "the SEC should keep this cost in mind".

In August, Floyd Norris of The New York Times wrote: "Much of Wall Street has argued that there is no evidence that short-selling caused the plunge last year, and the academic studies available do not support the idea." Indeed, much of the evidence suggests that short selling not only improves liquidity and contributes to a reduction in market volatility, but also helps to correct the prices of overvalued stocks.

The consolidation of the DFM and the NASDAQ Dubai announced last week might be a signal that short selling on local markets is moving towards a blessing from regulators. NASDAQ Dubai, a market based in the Dubai International Financial Centre and regulated by the Dubai Financial Services Authority (DFSA), already offers more than 100 types of derivatives contracts that permit investors to bet on stock prices to decline. Currently, however, brokers, asset managers and banks regulated both by ESCA and the DFSA are not allowed to trade in derivatives on the NASDAQ Dubai.

Many observers say an optimal and transparent regulatory framework is one of the pillars of Abu Dhabi's Vision 2030. Better regulation will help encourage foreign investors to take a longer-term view of the UAE's markets, increasing liquidity and reducing volatility. As plans are set into motion to bring the economy more in line with more developed markets, regulating and allowing short selling just might be something to consider.

@Email:[e-mail]