Regulation fears lead hedge funds to more than halve borrowing

Hedge funds have more than halved their levels of securities borrowing amid fears over pending regulation of the practice being discussed in Brussels.

Kevin McNulty, chief executive of the International Securities Lending Association, said securities borrowers held $1.8trn on loan, far below the $4trn pre-crunch levels.

Although hedge fund industry assets have breached their pre-crisis peaks, he said “we are not seeing that translate into real demand to borrow. Compared to historical demand levels, levels now are very depressed”.

ISLA cited fear over regulations, less use of leverage and long-bias as reasons.

Tammy Phillips, ISLA board member, added: “The world is a less short place than it was pre-crisis, and there is not the leverage being applied to strategies that hedge funds are employing.”

Richard Thompson, ISLA chairman, said uncertainty over which European rules on shorting – including around disclosure – would take effect was a major contributor.

“Hedge funds like to have a level of certainty over their ability to execute and live with a trade over time. If there is a sense that a physical short sale will present a challenge in the near future, that does act to deter putting the trade on in the first place. Hedge funds may look for other ways [to sell short].”

European politicians are currently discussing the main proposals to regulate shorting more tightly.

McNulty said ISLA supports full disclosure, he said – but in private, to regulators.

“Regulators need to see this information, because politicians scream and shout at them that short selling is out of control and causing all sorts of problems, and regulators need the hard information.”

But ISLA opposes another forcing hedge funds to reveal publicly significant net short positions.

“That can have very negative effects on the market and some the regulators would not want to see,” he said. It could result in funds blindly copying large rivals’ shorts, and artificial limiting shorting just below reporting thresholds.

McNulty added academic studies have demonstrated shorting aids price discovery, and market liquidity.

He also criticized proposals to force funds’ bankers to locate and reserve securities before short sales of them could be made. “That would create a lot of additional work and tie up a lot of securities in the market.”

McNulty added the market could suffer another contraction in inventory available if lenders find themselves defined in the eyes of regulators as short sellers, by lending out securities that they subsequently sell – which could expose lenders to stringent shorting rules, including on disclosure.

“We want to make sure investors do not end up with a situation where, if you’re a pension fund that has loaned and then sold shares, you are not held to have sold [them] short. If there is a risk pensions be seen as short selling, they may not lend anymore,” he said.

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