Debates between Baroness Noakes and Lord Sharpe of Epsom during the 2019 Parliament

Mon 8th Mar 2021

Financial Services Bill

Debate between Baroness Noakes and Lord Sharpe of Epsom
Baroness Noakes Portrait Baroness Noakes (Con)
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My Lords, I support the call of my noble friend Lady McIntosh of Pickering for a review of short-selling legislation, although I start from a very different position to her. As she explained, our short-selling rules were acquired via the EU, which is how they found their way on to our statute book. I believe that all EU-derived legislation should be reviewed at some stage; I am not sure this is the most pressing area, but it should certainly be reviewed.

When the EU introduced its short-selling rules in 2012, we had to follow, but it is far from clear that, left to our own devices, the UK would have introduced such rules. The FCA has been clear that the existing powers to trigger a ban on short selling would not be exercised lightly and the bar must be set very high. That must call into question whether we actually need the powers. The trouble with regulators is that, once they have powers, they never give them up voluntarily, even if they can never envisage when they would be used. A review would allow us to look at this again. We ought not to allow regulators to keep draconian powers to intervene in markets without very strong justification.

Against that background, I was particularly disappointed to see that the EU’s temporary—though extended several times—reduction of the threshold for notification of short selling, which expired when we left the EU, was almost immediately reinstated into UK law. That is not a good direction of travel.

There is nothing intrinsically wrong with short selling. It can provide liquidity to markets, improve bid-ask spreads and assist in price discovery; it also offers a route to hedging long-only exposures. There are, of course, downsides, including the potential for unlimited losses, so the risks have to be well understood and managed. We recently saw in the US that some hedge funds got their fingers burned on short selling GameStop shares due to action taken by amateur investors; but that merely highlights the need for sound risk management—it does not speak to short-selling itself being a problem or suggest that powers are needed for market intervention.

Lord Sharpe of Epsom Portrait Lord Sharpe of Epsom (Con)
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My Lords, I refer to my interests in the register. It is always a pleasure to follow the noble Baroness, Lady Noakes; it is also something of a challenge as she speaks so authoritatively on matters such as these and I often find myself agreeing with her.

The noble Baroness, Lady McIntosh, spoke compellingly in her introduction to this amendment. She made the point that she has misgivings about the practice. Clearly, for a practice that dates back to the first days of stock markets, short selling retains its ability to attract controversy. Indeed, a short seller was accused of manipulating the share price of the Dutch East India Company in Amsterdam as long ago as 1609. The noble Baroness, Lady Bowles, suggested that it is sometimes regarded as an evil practice, so I felt that it deserved a defender today.

The goals and effects of short selling are often misunderstood and, when markets enter a downturn, many are quick to call for short selling to be banned. While such bans are unfortunate, they have left us with a wealth of data on the effects of short selling and how the practice contributes to the proper functioning of markets. The practice of selling a stock short is always the same but the intention behind it varies considerably. At its most common and passive, short selling is a conservative investment technique used to hedge against risk, as the noble Baroness, Lady Noakes, has just highlighted, but obviously at the cost of forgoing some returns. On the point made by the noble Baroness, Lady McIntosh, about the volatile first quarter of 2020, the Alternative Investment Management Association, which represents 2,000 corporate members in 60 countries, reported that funds which had hedged in this way outperformed the broader market by 20%.

To be sold short, a stock has to be borrowed, and it will usually be borrowed from an asset owner for a fee. The fee helps the returns to the holders of that stock—in practice, anyone who participates in a long-term equity fund and, therefore, probably everybody involved in this debate. The fact of selling the stock helps create valuable liquidity, which is often essential to ensure the smooth functioning particularly of smaller markets, but it also works in reverse during periods of market turbulence. In practice, short sellers are often the buyers of last resort when markets are under pressure; they take profits in their short positions and therefore help to provide stability to markets.

The more controversial end of the short-selling spectrum is that populated by activist short sellers. They are often characterised as predators who create and exploit misery, but that is simply not the case. These investors act as the canaries in the coal mine. Short selling does not directly undermine the health of a company any more than buying its shares improves its fundamentals. Companies are not deprived of funds when investors sell shares, nor do they become financially stronger when investors buy shares in public markets. Short sellers cannot send a good business under. What they can do is expose bad business models, bad management, dodgy accounting, fraud and other bad behaviour. At a more mundane level, they can expose unjustifiable valuations.

There are plenty of recent examples but one will suffice as the regulatory reaction was instructive; here I am very grateful to Jack Inglis, the CEO of the Alternative Investment Management Association, who provided me with some detailed facts. In 2019, Wirecard in Germany famously went bust. It was at the time a member of the main German index, the DAX 30. The first queries into the company’s accounting practices date back to 2014, when short positions began to be initiated. However, when the pressure mounted on the company to explain itself, the German regulator instead went after journalists at the Financial Times who had published a deep dive into the company—and, of course, the short sellers. They filed a criminal complaint against them, accusing them of market manipulation, and, in February 2019, initiated a two-month ban on short selling the shares, citing the need to curb

“a serious threat to market confidence”.

As we all know, the company subsequently went bust, the subject of a multiyear fraud involving €1.9 billion going missing and the CEO being arrested, among other things.

Since then, Germany has become much more circumspect about joining other European states in banning the practice. Indeed, the regulator’s president apologised and paid tribute to those

“journalists, analysts or yes, let it be short sellers, who have been digging out inconsistencies persistently and rigorously.”

In saying this, he was following a long historical tradition—such bans are inevitably repealed.