Monday, July 28, 2008

Ban on "naked" shorting, not shorting

Time and time again, I've seen articles in the local newspapers where not enough research is being done, and the articles are not totally correct. Today I see the same thing again!

First, US ban on "naked" short selling of shares, not short selling of shares. Apparently there's a loophole where traders can short shares without borrowing when they do a "naked" short sell. Do read up on the wikipedia article here if you totally do not know what the heck is "naked" short sell.

Next, I totally disagree with the article that states that the market should not follow the US. My question is that does he think the police is an important part of the society? The obvious answer is of course yes. That's what the regulators role in the exchange. They are the "police".

The concept of the exchange is where there are a certain limited number of shares in the market for a company. Therefore, the price is based on a willing buyer, and willing seller basis. One can borrow the shares from a willing owner, and do whatever you wish to the shares, on the condition that you'll return it in x number of days. Now, you're saying that there's a certain rule that allows a trader to bypass this limited number of shares.

This totally distorts the pricing of the shares because
  1. The person who did the "naked" short did not even own the share. Therefore, how do the company shareholders stop this person from selling the company at a discount to its true valuation? For normal contra and short selling, you're able to control by just not allowing this person to borrow your shares. For this case, how do you control?

  2. If the shareholders of the company know what's the true valuation of the company, they would never sell it below a certain price. Some use the book value as the "base price" of the company. Do you think this person who "naked" short the share knows anything about book price or any other fundamentals for the matter? No way... See how many perfectly sound companies prices are being driven downwards due to the ignorance of such fundamentals, as the only thing that matters to them is the volatility of the share price.

  3. "Naked" shortists would have the power to control the pricing of the company, and bring a perfectly sound company to its knees. Add the "rumours" and you will see some takeover "actions".

If nothing is done to close this loophole, I can think of some consequences:
  1. Rise of private equity as private equity will at least buy at a slight discount to your true valuation. Most will buy above valuation.

  2. All the good and sound companies will flock to these private equity investors, or angel investors for capital.

  3. All the remain good and sound companies will find ways and means to delist since the shareholders are no longer value adding to the company, and true valuation is out of the window. Either that, or they will be taken over by bigger fishes that see a very good bargain, and delist it from the exchange.

And guess what? All these things are happening right now, at this instant. Some exchanges have already lost sight of the original fundamentals of a public stock exchange. Very soon, they'll see the ill-effects of this kind of loopholes, and by then, it'll be too late because a stigma has already been attached to it.

To all future companies that wants to go the IPO route, good luck to you... I think you're better off attracting private equity funds, or private companies. At least you get a true valuation.

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