Richard Steele, Executive Director, J.P. Morgan Securities Lending Product Development, considers the impact of the short selling regimes introduced by financial regulators around the world in 2008 and ponders on the future shape of regulation in this important but little understood area of the financial markets.

During September 2008, as the growing crisis that had engulfed financial markets entered an acute stage, events were moving so fast that regulators around the world had limited room to maneuver. At a time of extreme market turbulence, manifested in high and prolonged price volatility and downward pressure on the prices of financial stocks, short selling is one area that seemed to cry out for urgent attention. Regulators, concerned by the heightened risks of market abuse and disorderly markets in these conditions, seemed to be taking immediate and positive action in this regard.

The U.K. Financial Services Authority (FSA) led the charge by introducing a temporary ban on the short selling of financial stocks, effective at midnight on September 18. The next day, the U.S. Securities and Exchange Commission (SEC) followed suit, as did many other financial regulators the following month.

As the G-20 leaders arrived in Washington, D.C. in November to discuss steps to address the global financial crisis and ways to mitigate future crises, they could not have missed a 12-page open letter landing on their desks from International Organization of Securities Commissions (IOSCO), the organization that brings together more than 95% of the regulators of the world’s capital markets.

In addition to offering IOSCO’s assistance in exploring regulatory solutions to the crisis, the letter highlights some of the shortcomings which many now believe contributed to the calamitous events in 2008. It concluded that regulatory gaps, such as those posed by certain unregulated or underregulated products, must be closed. Secondly, it had also become increasingly clear that, while financial regulatory structures may remain national, consistent global solutions were required.

While the popular view might see short selling as a prime example of an unregulated product requiring more stringent control, the work of IOSCO’s Technical Committee Task Force on Short Selling has been framed as working “to eliminate different regulatory approaches to ’naked’ short sales, including delivery requirements and disclosure of short positions, while minimizing any harm to legitimate securities lending, hedging and other transactions.”

Industry response to this development has been very positive, especially as the relatively piecemeal and inconsistent manner in which various countries applied short selling regimes has exacerbated liquidity concerns and made compliance more difficult. On December 5, members of the Securities Industry and Financial Markets Association, the International Securities Lending Association and the Pan Asia Securities Lending Association collaborated to send a letter welcoming the goal to agree a common international approach with respect to regulation of short selling, and expressing willingness to work with IOSCO on this subject. As a committee member, J.P. Morgan has been actively involved in these developments.

Given the many challenges that remain, it would be too much to expect things to change overnight. However, as one of a number of areas requiring urgent remediation by regulators, a consistent a global solution to the regulation of short selling cannot arrive too soon if policymakers and regulators truly are serious in their desire to build investor confidence through measures such as strengthening cross-border enforcement cooperation, enhanced transparency and disclosure with respect to all financial products.

While the fragmented national approach to addressing short selling remains, J.P. Morgan will continue to perform daily compliance reviews across the 32 securities markets that are currently offered in the discretionary securities lending program.