The recent crisis in the American financial market, with its consequences on global markets, has been commented by just about every vehicle in the media. The causes, the forms of emergency handling of the problem and the measures that should be taken to avoid the reoccurrence of the phenomenon have all been thoroughly discussed. During this process, one specific characteristics of the system has been identified as an amplifier of damages to the market: short selling of securities, especially stocks. When the crisis revealed itself inexorable, the regulator in the US issued measures soon adopted by other countries, directed at suspending or prohibiting short selling of stocks.

Would it also be necessary to regulate this practice in our market? Probably not. Brazil has implemented a set of regulatory and prudential measures that place the country at the forefront of safe and transparent markets. In this sense, banning short sales would not only eliminate one of the financial system’s most important characteristics, but would also introduce a restriction as improper as the capping of interest rates.

SHORT, BUT NOT MUCH – Normally, a short seller sells stocks that have been borrowed from an investor who owns them. In some countries, it is also possible to sell stocks without previously borrowing them. In this situation, the buyer (of the rented, and now sold, stocks) becomes entitled to the stock, but the transaction is not consummated (financial liquidation and recording of the purchase in his name) until the stock is effectively delivered. This special situation is widely known as naked short selling. In Brazil, the rules in place do not allow it. There are punitive rules that inhibit the non-delivery of stocks at settlement (D 3).

Short selling can be considered socially desirable, for it supports a market price controlling system that hinders strong deviations from the stocks’ fair price (understood as the consensus value among active investors). It would, therefore, be as desirable as some institutional control mechanisms (the checks and balances) that preserve democracy.

There are many who support the idea that bubble bursts and spot crises, like the one experienced on September 11, 2001, would have gained larger proportions if it weren’t for the prior adjustment in stock prices brought about by short selling. Past experiences, such as the Nahas case in Brazil, demonstrate that one-way markets create unsustainable threshold-situations that inflict great harm to society. We can only condemn short selling (as they exist here) if we go by the understanding that there should only be “covered” active investors and that the additional volatility (and, likewise, liquidity) provided by short selling is undesirable.

It is also necessary to take into account the fact that the financial system’s fundamental equation is based on two parameters: risk and return. As every financial operation involves a counterparty and not all participants share the same risk and return expectations, it is reasonable to suppose that many operations that we see carried out only take place because one of the parties involved has adjusted the symmetrical risk to which he is exposed to his own expectations. A significant portion of this adjustment is implemented through derivative instruments “calibrated” by way of short sales. Without them, it would be impossible to carry out the ordinary “delta hedging” of positions in options.

Past experience has shown that one-way markets create unsustainable threshold- situations that end up harming society

Still from the perspective of derivatives and structured operations, it should be remembered that many stock purchases have been implemented by the issuers themselves. These operations are carried out either directly, via buyback programs approved by the company’s boards of directors, or indirectly, via swap operations procured from banks or other market agents. Without getting into the merit of such programs, we can suppose that the “value protection” (or price enhancement) brought about by these deals might take the security beyond its point of equilibrium. such case, active investors, with a different value perception could help counterbalance eventual spells produced by overconfident administrators and avoid the formation of localized value bubbles.

For these reasons, and unless one wishes to rediscuss the existing financial system’s framework, weighting in all the consequences that such measure would produce, we regard most initiatives to inhibit short selling as undesirable. Of course, this does not preclude some local actions for specific reasons. One example of the call for reflection involves the role and modus operandi of hedge funds (our multimarket funds). We know that many of these funds engage in strategies deemed “long/short”, through which they set on changes in the relative appreciation of assets without necessarily positioning themselves in relation to market movements. The execution of this strategy depends on stock borrows. Cohibiting this activity would put a halt on such strategies. Is this what we want? We believe not, but in any case, it would be impossible to advance significant changes in the way of doing business without a profound rediscussion of the practices in place and of the impacts that change in current regulations would entail.

DIFFERENT WORLDS – Short selling in the United States goes about differently. Suffice it to say that investors (final beneficiaries) are only identified by their brokers. It is possible to “create” stocks (via naked short sales) for up to 18 days (and, through certain artifices, even longer). There are no shorting limits (there has been news about short positions of over 50% of a company’s float), neither daily reconciliation of all positions held on individual accounts.

In other words, it’s an environment where leveraged speculation (legitimate or otherwise) around the value of a company’s stock can really expand the effects of a crisis. Furthermore, the system does not preclude the existence of undisclosed outstanding positions, which means to say the system does not guarantee the inexistence of virtual stocks created by deviant brokers.

In Brazil, it is not possible to engage in naked short selling without incurring strong penalties and, furthermore, there are free-float boundaries to borrowing activity (thus, the unfettered expansion of stock claims is not possible). There is total transparency in rented positions (disclosure in just about real time) and, most importantly, there are no doubts whatsoever as to the positions held at any time by investors (a central record system daily reconciles all positions held). Hence, the existence of virtual positions in the system is something unthinkable of.

Finally, it is important to bring out that Iosco, the international organization of securities commissions, highlights “the important and market-beneficial role” of short selling, leaving to each regulator the discretion to define the role of this activity in each jurisdiction.