Time for Gulf stock market regulators to introduce short selling

Mohammed Al Hashemi

Stock market regulators in the Arabian Gulf should put the introduction of short selling at the top of their agenda, despite worries it would further depress share prices, because the practice builds long-term confidence by increasing trading volumes and investor choice.

Short selling – which allows investors to make gains in a falling market by borrowing a security, selling it and agreeing to buy it back at a lower price – plays an important role in developed capital markets.

It makes price discovery more efficient, increases market liquidity, smooths volatility and provides investors with a host of risk-management tools.

However, GCC countries have been reluctant to allow the activity because of concerns that downwards movements in markets would be accelerated or accentuated. The relatively low liquidity and limited depth and breadth of regional markets have often been cited as reasons why the practice would be inappropriate.

But with the UAE and Qatar upgraded to emerging market status by the index provider MSCI, and Saudi Arabia opening up further to foreign investors, the region’s markets are now attracting a more sophisticated and global investor base. These investors are likely to be frustrated in the long term, if they do not have access to tools common in other markets.

The ability to short is a form of insurance for investors, protecting them from losses during downturns. And because it allows investors to benefit, even if a particular stock is overvalued, there is a powerful incentive for them to devote more time, effort and resources to scrutinising the value of individual companies. This increased transparency makes it more likely that stocks will be priced accurately, mitigating price bubbles and offering regulators a useful way of anticipating trouble in markets.

Over the past decade, GCC governments have pursued the regulation of shorting with varying degrees of enthusiasm. Kuwait, the oldest established stock exchange in the region, has advanced the most by introducing rules in 2005 that explicitly permitted the activity, along with the trading of futures, forwards and options products. In 2012, the UAE’s Securities and Commodities Authority (SCA) followed suit by authorising both stock lending and short selling, but restricted their adoption by limiting them to licensed market makers.

While the Qatari government has considered drafting similar rules, Oman, Bahrain, and Saudi Arabia are still significantly behind. Despite this, unregulated short selling has been taking place in several of these countries for years, through synthetic and opaque mechanisms.

GCC authorities have been reluctant to authorise shorting and associated derivative products for a variety of reasons, but mostly because of a fear that it contributes to stock price declines. The thinking is that it would be harmful to and dimly viewed by local individual investors, who are unlikely to employ short selling as a tactic. And it could even be seen as unpatriotic if the stocks affected are partially owned by GCC governments, as is the case for many regional banks, telecoms operators, insurers and real estate developers.

There is, however, little proof that short selling actually exerts downwards pressure on markets. For example, an in-depth study by the New York Federal Reserve in 2011 found that share price declines during the 2009 financial crisis were not driven or exacerbated by short selling. And bans on short selling by many regulators across the world did little to prevent stocks from falling.

Regulators may also view short selling as un-Islamic, owing to the high levels of risk involved, the potential for speculation and the potential for investors to accumulate losses. Selling a stock short unsuccessfully can lead to expensive stock buy backs, and even to bankruptcy.

It is right for regulators to look at all the pros and cons before introducing new market practices.

However, it is also important to recognise that developed and emerging markets across the world have introduced shorting and associated derivative products, with little problem. By helping markets become more efficient, transparent and liquid over the long term, this could be an important step to attracting more local and international institutional investors and improving access to capital.

Mohammed Al Hashemi is the head of asset management at Invest AD


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