Wednesday, September 24, 2008

(Un)intended consequenes? Shorting ban raises liquidity fears

(FT) Trading volumes in financial stocks could dry up after the computer-driven hedge funds – the biggest traders in stock markets – have been hit by bans on short selling.

Several statistical arbitrage hedge funds, which use computers for rapid-fire trading, said they have already stopped dealing in financials because their models only worked by offsetting the risk of long positions by taking short positions, too.

At least two have closed small equity trading books altogether because they cannot be sure their computer models will work without the financials, which make up about 10 per cent of US and UK stock markets.

“If it continues long-term it will take liquidity out of the market and increase the volatility because it will take so many people out of the market,” said a manager at one of the largest statistical arbitrage traders.

Short selling, where traders aim to profit from falling prices, has been temporarily banned or restricted in markets around the world.

It remains too early to measure the full impact on the market, but the statistical arbitrage funds are widely seen as providers of liquidity, smoothing price moves and making trading cheaper by narrowing bid-offer spreads.

Karsten Schroeder, chief executive of $800m London hedge fund Amplitude Capital, has closed a $15m internal portfolio of US equities which had been running as a test for a launch of a new fund next month.

He said it was clear the new rules were “completely useless”, as demonstrated by falls in the market this week even after shorting was banned.

“The reason we short a stock is not because we have a political agenda, it is because the stock is overvalued,” he said.

Winton Capital, a big hedge fund specialising in trading futures, has closed a small equity portfolio it ran as part of its Evolution fund because of the rules, as it was not sure its computer models would work without financial stocks.

AHL, the flagship hedge fund of London’s Man Group, has stopped trading financial stocks in its equity long-short book, which made up only a tiny proportion of its mainly futures-based fund, but it continues to trade the rest of the market.

The rise of statistical arbitrage hedge funds able to trade in microseconds has been a boon to liquidity as well as to the trading volumes that boost the profits of big exchanges.

Their withdrawal from the financial sector could have a big impact at a time when investment banks, who provide liquidity through market-making operations, face severe capital constraints.

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