A butterfly flapped its wings and a storm was created on the other side of the world. So what was the butterfly in the credit crisis? Was it a home loan made to someone in the US who could barely afford the payments when times were good? Was it the bundling of that loan by unregulated mortgage providers with other mortgage loans to create mortgage-backed securities?
What was the cause of the recent troubles of Northern Rock, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Merrill Lynch, Morgan Stanley and Goldman Sachs? Did hedge fund managers create the problem? Was short-selling the problem? Or was government intervention or the lack of government regulation the problem?
It will take regulators around the world some time to determine whether anyone violated the law and manipulated the markets using methods akin to the secret service during the Cold War (with more gossip and rumour than the latest issue of Heat magazine). They may find that some people did break the rules, and those people will be punished. However, they are also likely to find that the vast majority of the short-sellers operated within the rules in place at the time.
The events of the past couple of weeks have underscored the fact that global financial markets are interdependent – an event in one market will have ripple effects through other world markets. This has been the case for many years.
Until recently, however, the world’s financial regulators have taken a relatively silo-like approach to regulation of their markets. It is in the past 10 years that the pace of cooperation and coordination among financial regulators has gradually increased.
When the US Securities and Exchange Commission (SEC) and the UK’s Financial Services Authority (FSA) banned short-selling in financial firms, many other regulators around the world – including those in Australia, France, Germany, Ireland, the Netherlands, Spain, Switzerland and Taiwan – also banned or limited short-selling. The SEC stated in its press releases that it had worked in concert with the FSA on the shorting ban and the SEC amended its ban on short-selling the securities of financial firms over the weekend to better align its ban with the one the FSA had imposed.
The short-selling bans may be evidence of an acceleration of the regulators’ move to work more cooperatively as it becomes clearer that no single regulator working to regulate its own market can do enough any more, given the nature of the global marketplace.
As the investigations continue into whether anyone has broken the applicable short-selling rules and manipulated the market, I expect that we will see the regulators continue to work together by cooperating with one another in investigations and enforcement actions.
Following all the investigations and any enforcement actions, and once the global markets have settled, regulators will need to consider whether, and to what extent, short-selling should be further regulated and whether the potential effects that short-selling in one jurisdiction may have on the markets in other jurisdictions necessitates a coordinated set of regulations adopted by multiple financial regulators.
Up to now, most major regulators have permitted short selling on the basis that it adds efficiency and liquidity to the marketplace. Will short selling become the new smoking? Will a practice that was once accepted be banned or strictly limited to safeguard the health of world markets?
Two things seem certain, though: the future of the regulation of short-selling will inspire debate around the world, and the world’s financial regulators will be working cooperatively.