Shorting is here to stay but execution techniques may be changing

Is shorting changing? Do funds use prime brokers to borrow the instrument itself or use derivatives to achieve the same ends?

Despite shorting bans and threatened regulatory changes, it is clear that hedge funds will still be using shorting as one of the mainstays of their strategies. A variety of views, however, has emerged over just how shorting will be achieved in the future.

Some believe there are still supplies of primary instruments while others are convinced synthetics will be the way of the future, not least because of lower prices and limited counterparty risks.

Clearly leverage is not as freely available and that, too, is expected to have a long-term impact on the way hedge funds use shorting to achieve returns.

Prime brokers are still at the centre of the process and although some have cut back on this service, there is a demand which is expected to continue into the future. With the rise of regulated Ucits funds within Europe, the use of derivatives for shorting will also increase. This is likely to lead to an increase in the use of instruments such as exchange traded funds (ETFs).

While shorting remains a useful tool used by hedge funds, how it is achieved in future could significantly change as a result of the financial upheavals of 2008 and the subsequent regulatory response to that crisis.

Patrick Blessing, Scotia Capital
The short side of the market is often misunderstood owing to the over-the-counter (OTC) nature of the business. It is also, at times, misrepresented. Within specific relative value and event-driven strategies, the purest form of hedge is often the physical instrument itself to avoid mispricing across different security types. This type of shorting will always exist. However, during the various shorting restrictions implemented late 2008 in many different regions around the world, managers were scrambling for ways to hedge out exposures. At that time managers did look to derivatives to get their short exposure either via synthetics, futures, options - both exchange traded and OTC. The experience of 2008 has definitely expanded the minds of managers to gain short exposure via derivatives, particularly when the physical instrument becomes inefficient, or impossible to short. From a prime brokerage point of view, it can create complexities to ensure you are reflecting the true 'risk' of the position. However, the increase in trading these instruments has made it much more commonplace.

Jayesh Punater, Gravitas Technology
Although overall trading volume may decrease if the US Securities and Exchange Commission (SEC) implements the uptick rule on short-selling, the longer-term benefits are positive. Traders would only be able to make short sales at a price higher than the current best price, making it practically impossible to short-sell. Funds believe this would not allow prices to reach the low point they did in 2008. Preventing further 'bear raids' should leave the market more stable and help prevent the massive taxpayer bailouts of 2008. The SEC's actions may also encourage innovation. Banks have been less eager to lend stocks to funds. Funds have looked in different places to find these stocks, including traditional asset managers. This alteration to the trading environment has changed the way traders are shorting. In many cases they will also represent shorts on stocks by buying their competitors or in the case of foreign companies, conducting currency trades. This eventually may lead financial services companies to come up with new structured products allowing companies to short.

Magnus Ward, SEB
The way hedge funds have been shorting has been changing for quite a few years. In the early days there was a large reliance on the prime brokers for stock lending so that shares could be shorted. This was already challenged by the advent of synthetic prime brokerage where funds started creating short positions using contracts for differences and similar products provided by a number of banks. On the back of the 2008 crisis, there has been a further advance by certain funds to use ETFs to achieve the same results. The driver is to reduce the counterparty risk inherent in the OTC products. However, there is still a large difference among funds over which products are preferred. On the one hand we have the fundamentally driven long short equity funds which tend to use prime brokers, often multiple prime brokers; on the other there are the statistical arbitrage funds that for various reasons prefer derivatives. If banks and prime brokers want to stay competitive, it is important that they offer all of these solutions. The funds will choose the one that is most beneficial at a time.

Mike Rosen, Concept Capital
There is a considerable likelihood of further regulatory restrictions on the short side, including an existing but loosely enforced locate before short rule, a potential resurrection of uptick rules in some form and a heightened disclosure of short positions. For now what I see are hedge funds continuing to trade the short side as they always have. Funds are, for the most part, unable to achieve any meaningful rebate on shorts due to the current interest rate environment and the increased cost on some difficult to borrow securities. This set of circumstances causes a diminished economic benefit of carrying shorts. Despite all of this, we have seen little structural change and prime brokers are really the only place securities are borrowed. Our clients still maintain a sizeable portion of their investment portfolios in short cash securities and ETFs and have kept their net exposures at remarkably consistent levels over the past year. Gross exposure has increased, primarily due to the appreciation of the underlying assets.

Hamlin Lovell, independent investment consultant
When stock borrow becomes difficult, expensive or impossible to obtain, hedge funds will choose alternative methods.

They could create a synthetic short on one or more stocks through shorting an appropriate sector based ETF and buying its constituents that they do not wish to short. ETFs are nearly always borrow-able.

If no such ETFs exist, hedge funds may enter into a total return swap with one or more counterparties to isolate the names they wish to take a view on.

Exotic option structures such as one touches can be another route. Thinking laterally, if equity avenues prove a dead end, they may express the same view via the credit derivatives markets.

They could buy credit default swap insurance on one or more names, or try to short bonds, loans or convertibles from an issuer.

Aoifinn Devitt, Clontarf Capital
Many hedge fund managers we follow tend to falter in their execution (as opposed to their generation) of short equity ideas, whether through encountering difficulties in sourcing the borrow, controlling the size of the position if it moves against them or in riding out a short squeeze. While the threat of more regulatory action continues, the crowding that was once the bane of short sellers' existence has abated. Anecdotal evidence suggests while prime brokers are clamping down on leverage, stock borrow remains available, with the exception of perhaps the most crowded names. General investor scepticism towards opaque instruments and leverage has actually led to less use of derivatives as substitutes for actual shorting of equities in our experience. This is also the case in the area of fixed income. The use of CDS had seen a surge in popularity. The experience of the 2008, particularly in Asia, has caused many managers to avoid the area, at least until some form of a clearing house is introduced.

Gideon Margo, Key Asset Management
Generally speaking we have not witnessed a long-term change in the way hedge funds use derivatives over stock lending facilities. It is fair to say that during periods when managers want to increase their short exposure very quickly, they are likely to do so via derivatives - specifically equity index futures. Additionally, in the current environment managers are finding fewer opportunities to short single companies, so are using more index futures to hedge. While both these scenarios are a reflection of the environment, we do not believe managers will necessarily be using more derivatives than stock borrow over longer periods. However, growing investor appetite for products such as Ucits funds, where they make extensive use of derivatives, will have a positive impact on demand for these types of instruments. The same can be said for higher frequency trading hedge funds (such as CTA and equity trading strategies) who make more use of derivatives than stock borrow. These products are also more popular today than they have been.

Brian Cahalan, BNP Paribas
In US markets, clients continue to express their single stock short interest through cash prime brokerage. Short interest on the NYSE has increased for August 2009, following a dip in July, even in the face of a rising market.

The cash prime brokerage product offers certain advantages for short sellers, such as liquidity, depth of borrow pool, anonymity and stability, which the derivatives markets cannot always compete with.

Cash prime brokerage has also been able to provide risk-based margin levels that are competitive with over-the-counter products.

While clients may use other products to express a more macro viewpoint, single stock risk continues to be primarily expressed through cash prime brokerage and securities lending markets.

Sonja Uys, Insight Investment
We use derivatives (synthetic shorting) to achieve short exposure rather than physical short selling. The key advantage of using derivatives is you are able to obtain more competitive pricing and are not constrained to one price as given by your prime broker. Another benefit is that the counterparty credit risk relating to the derivatives contract can be mitigated through collateralisation. Using a prime broker often involves an agreement of rehypothecation resulting in an increase in the credit risk the fund has to the prime broker. Given that synthetic shorting does not require the fund to borrow from the prime broker, it normally means rehypothecation might not apply, thereby reducing the credit risk to the prime broker. Finally, the use of derivatives tends to be more operationally intensive as it requires additional systems and expertise ranging from risk and collateral management to the legal knowhow for negotiating the ISDA agreements. It is not hard to foresee the industry making greater use of synthetic shorting, given the benefits that it provides.