regulation under fire

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    Regulation under fire
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    There will be a lot of sympathy within the battered corporate community, particularly among financial stocks, for the attack by QBE Insurance Group’s chairman, John Cloney on the ASX. The fact that the Australian Securities Exchange’s dual roles as for-profit market operator and market regulator creates a conflict is inarguable; whether it has contributed to the market volatility is, however, a different and more difficult question.

    Cloney told QBE’s annual meeting that the group was "firmly of the view" that the ASX had a conflict of interest. It wasn’t in the exchange’s interests to take steps that decreased trading volumes.

    "They clip the ticket for every transaction, so the more transactions the better," he said. QBE wants regulation of the securities markets to be transferred to the Australian Securities and Investments Commission and new disclosure rules to be introduced to protect smaller shareholders.

    This isn’t a new debate, but it is one that has been given a sharper focus by the ferocity of the bear market and the associated steep falls in share prices and apparent large increase in short-selling and hedge fund activity. Anecdotally, some hedge fund activity involves a deliberate combination of rumour-mongering and short-selling, which would equate to market manipulation, an offence.

    QBE’s share price has fallen from around $33 at the start of the year to around $25, with Cloney saying that in the three weeks after announcing its 2007 results on February 26, 24 per cent of its shares had been traded, compared with about 9 per cent in the same period of 2007, and the daily average volume had almost trebled to 10 million shares. Significant short-selling had occurred and "unfounded rumours" had added to the share price volatility.

    The frustration of Cloney and others is that the regulators have been unwilling or unable to act to moderate the destructive aspects of recent market behaviour. Particularly controversial has been the apparent massive increase in "covered" or unofficial short-selling using borrowed stock.

    "Naked" short-selling is regulated by the ASX, which limits trading to an approved list of stocks with substantial liquidity, regulates the price at which shares can be sold short and requires disclosure of short positions to the exchange.

    The ASX has spoken of a "definitional ambiguity" in relation to covered short-selling – technically someone who borrows stock owns it, even if there is a back-to-back agreement to later return the shares to the lender. That places covered shorts beyond the ASX’s regulatory ambit and into a grey area, or loophole, in the Corporations Act that the Federal Government has said it will legislate to remove.

    The Opes Prime collapse has revealed a scale of margin loan and stock-borrowing activity across the corporate sector – and most particularly at the junior end of the market, where naked short-selling wouldn’t be allowed – that was hitherto unrecognised.

    The ASX can encourage brokers to report covered short sales, but it can’t force their clients to inform the brokers that they have borrowed stock. It also says, incidentally, that it can’t regulate the non-broking services – like margin lending or stock lending – offered by the firms it regulates.

    There is nothing inherently wrong with short-selling. Its supporters argue that it adds depth and liquidity to the market and creates more efficient pricing, as well as helping to identify flawed business models.

    In a 'normal' market 'normal' short-selling is probably a useful feature. Even in the panicky conditions of the past five months conventional short-selling isn’t necessarily evil or destructive – unless it is accompanied by some form of market manipulation – which is more ASIC’s responsibility than the ASX’s.

    One has to wonder, however, whether allowing short-selling in stocks with very limited liquidity – and a lot of the Opes Prime portfolio would fit that description – wasn’t always going to end in tears. By turning a blind eye to the explosion in covered short-selling, the regulators and legislators share some responsibility for the outcomes.

    Cloney is right when he says we need more effective regulation. We need, and the Government will hopefully deliver quickly, more disclosure of all short-selling – complete visibility for all short positions would create a real risk for the traders that the market would trade against them to create 'short squeezes' or 'bear traps', which would discipline their behaviour – and we also need confidence that the regulators will jump on any suggestion of market manipulation.

    That doesn’t necessarily mean we need to remove ASX from its limited but vital role as the regulator of disclosure by sharemarket participants.

    The ASX has long argued, correctly, that it is in its own commercial interests that participants have confidence in the integrity of its markets – that the apparent conflict can be reconciled by its need to protect the reputation of its markets. It is better-placed to regulate commercially and in real time than ASIC, which is by statute a black-letter law regulator without the flexibility available to ASX.

    The real issue isn’t so much how the regulatory responsibilities are divided but how effective the regulators are. At this point neither of the primary regulators has distinguished themselves.

    Whether that’s because of their own inadequacies, or conflicts, or omissions in the legislative tools they have been given, is something that will inevitably be debated in the post-mortems that will be conducted when the market cycle stabilises.
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