In an inspired move, the FSA just announced that short-selling of shares will be disallowed in the UK until at least Jan 09. This tops off a dramatic and scary day on the UK financial markets. The ban only applies to trading some 29 banking shares – the list can be found here. To my own knowledge, this is an unprecedented move which has never taken place before (please comment if you disagree)

Short selling: Short selling of shares is a practice whereby a bank or a financial institution borrows shares from another market player, then sells them, before actually buying them back shortly afterwards and returning the loaned shares back to the original owner. This practice is a legitimate trading operation and is executed when a financial institution expects the price to fall – hence realising a profit when buying shares back at a lower price than the price at which they were initially sold ealier. The problem with this practice is that it can be, and is, taken advantage of in highly speculative trading strategies which under particular conditions can seriously destabilise financial markets when the price starts falling uncontrollably.

Very dangerous stuff: It seems that this practice has been increasingly widespread with various market players in the past few years, notably hedge funds, in chasing quick profits. Dangerously, it can be accompanied by spreading of false rumours about a company’s stability, which can cause its share price to crash. After this has taken place, the financial institution responsible for the false rumour can make a large profit when buying shares back.

It’s probably not illegal to do this, unlike insider trading, but it is certainly totally and utterly unethical.

This has happened before: This often destructive strategy of uncontrolled short-selling has caused serious trouble on UK financial markets in the past. The net effect is that shares can be in freefall and nothing can stop their decline as panic sets in and everyone starts selling, further depressing the price. September 2008 is probably the worst example of this type of calamity. HBOS shares in particular have fallen prey to short selling on a massive scale over the past few days. But this has happened before during financial crashes over the past 10 years.

Let’s hope the FSA can reverse today’s meltdown in the UK financial markets.