Technology is key to managing the complexity of global short selling

Key Takeaways

• Short selling plays a role in improving market efficiency
• Challenges include complex and changeable regulations
• Trusted partners and integrated tech solutions can mitigate risk

Short selling is a widespread trading strategy and a key tool for broker-dealers and active investors worldwide. But shorting brings exposure to more than market risks. There are also a range of different exchange rules and regulatory regimes associated with short selling. For firms operating across multiple markets, global variations in regulation are a consideration. There are several ways that firms can manage these risks, and technology solutions play a key role in effectively implementing them.

How short selling works and the risks involved

Short selling aims to allow investors to profit from falls in the price of a security. The short seller borrows shares before selling them. They then buy the stock back to return it to the party they borrowed from. If the stock’s price has fallen in the meantime, the short seller will profit from the entire transaction. Short selling can contribute to overall market efficiency by increasing liquidity and allowing quicker price discovery. It also offers long-focused investors the opportunity for additional income through lending stock.

However, the strategy has inherent market risks. If the stock price rises, shorter sellers can in theory face unlimited losses. This risk can be compounded if other short sellers are creating additional demand on the buy-side, driving the stock price higher.

The risks and complexity of short selling mean that both exchanges and regulators tend to have stringent rules for how and when it can be carried out. For example, so-called ‘naked short selling’ (the practice of selling stocks without first borrowing them) is widely banned, both due to the settlement risk to individual participants, and systemic risks of market manipulation.

Likewise, most jurisdictions have ‘locate rules’ (such as the SEC’s Regulation SHO) detailing short sellers’ obligations to ensure that they are able to borrow a stock before selling it short. Regulators may take wide-ranging punitive action against breaches in short-selling rules; for example, South Korea currently has a ban on all short selling until it can deploy a more effective monitoring regime and has levied multi-million dollar fines for breaches of these restrictions.

The stringent regulatory environment worldwide presents its own risks to market participants, especially those that operate in multiple markets globally. Complying with the specific requirements of each individual jurisdiction is a major challenge.

Responding to compliance risks

One potential solution is to outsource the regulatory risk by trading with alternative instruments. Swaps allow buy-side firms to gain short exposure to these markets while having the sell-side firms handle the regulatory complexities and risks. The execution of short-sell orders is subject to uptick rules in various markets. This prevents traders from executing orders at intended price levels in a timely manner.

Moreover, some stocks are short-sell restricted. These rules have led to the demand for synthetic short via long sell, which allows a buy-side firm to get short exposure via long sell orders. Swaps and similar equity-linked instruments allow participants to gain exposure to shorting in global markets, without taking on the overheads associated with compliance.

Where firms need or decide to carry out short selling directly, compliance needs to be central to trading operations. The challenges here are considerable, given that short-selling regulations are complex and frequently updated. Firms must balance the overheads associated with compliance against the need to for operational efficiency.

How technology can make a difference

Effective use of technology lies at the heart of all the potential responses to the compliance risks of short selling. A comprehensive order management solution can empower short selling with confidence in a range of ways:

• Integrated risk management: Fully integrating risk tools within the order management system allows regulatory requirements to be implemented with maximum efficiency. Controls can be implemented across the organization and trading activity can be restricted as required. Such integration also makes it easier to apply changes quickly in the event of regulatory updates.
• Market access and flexibility: Platforms that empower access to a wide range of markets and instruments also provide a key advantage. Integrated support for diverse workflows, such as swaps trading, allows firms to take a flexible approach, and access the benefits of short selling indirectly.
• Comprehensive data: One of the key ways that technology solutions can enable effective compliance is by supporting enriched market and order data; for example, short-sale approval indicators in instrument data, or locate broker information in order data. Such data makes it easier to monitor short-sale orders and stay up to date with regulatory requirements.
• Expertise: Global technology partners can bring an understanding of the regulatory environments in different jurisdictions, and ensure that their solutions are set up to enable compliance.

A comprehensive and integrated technology solution, delivered by a trusted partner, allows you to minimize your compliance overheads and focus your resources on achieving business goals.