'Banning the practice will not help'

Within one week in September, the world's financial markets were turned upside down with many of the greatest virtues of capitalism labelled as the reincarnation of evil, as investors ran for cover and governments across the world stepped in to stem the rot.

Terms like short-selling, derivatives and deregulation became dirty words and were trooped around as criminals in a police line-up.

So what does it mean for the regional markets that have been looking to emulate the pits of the New York Stock Exchange and the City of London?

"The single most important lesson to learn from the crisis is that markets must have effective risk management. Managing and mitigation of risk must be paramount and the system should not be overexposed to any one sector," says Bryan D'Aguiar, head of research at NCB Capital.

That ship may have already sailed as banks in much of the Gulf are already heavily exposed to construction and related sectors, some of which looks very vulnerable right now.

On a wider scale, the western fin-ancial market model was going to be the great template for regional authorities to follow, but that blind faith in the system has now been shaken.

Short selling, for example, which is illegal in regional markets, was being tolerated by the authorities as they were looking to introduce it at some point in the future. Not anymore. That instrument may be mothballed for some time to come, as regional regulators look for stability rather than fancy financial wizardry from opportunistic traders. Some might argue that's not a bad thing, but proponents of short selling say that it allows investors to act on stocks they feel are overvalued.

Regulation resurgence?

There is a danger that the current crisis will hamper liberalisation and innovation as regional regulators are concerned that markets are not ready to manage derivatives and other newfangled financial instruments.

"Absolutely, I think regulators in the Gulf and across the world are cautiously looking at all these complicated products that have caused havoc on Wall Street - they are going to be cautious in going forward," says Shahid Hameed, Head of Asset Management GCC, at Global Investment House. "They will be taking smaller steps to improve the market at the expense of some of the more sophisticated products - which does make sense."

The 're'-regulation could impact regulators such as Dubai Financial Services Authority and Qatar Financial Services Authority, which closely track the regulatory environments of the United Kingdom and other international markets that are going through a regulatory resurgence.

"The tighter regulations in international markets will flow back into the region as well," says Haroon Ahmad, Head of Business development at EIS Asset Management.

While some sectors such as banking and real estate will likely see a slowdown as a direct result of the global crisis, other areas may also see growth dry up.

The sukuk market for example, which was thriving on innovation from international and regional banks, had been experimenting with clever products such as Islamic credit swaps. That kind of innovation will be pushed back as "issuers go back to basics and shun the more sophisticated instruments," says Sean Daykin, head of investments at EIS Asset Management.

International banks were behind much of these innovations, but as they face the wrath of regulators on their home turf, they are less likely to push new products in the region. In any case, Gulf regulators may not be too enamoured with them either at this stage.

Other key lessons that regulators must take to heart are corporate governance, transparency and the protection of shareholder's interest. According to corporate governance watchdog Hawakamah, Gulf companies could improve their combined market cap by about 15-30 per cent if they apply more stringent transparency rules. Otherwise, opacity will lead to depressed markets, as has been seen in Dubai lately.

Many senior industry observers have also called on regulators to encourage regional fund managers to focus more on domestic investors, rather than international hedge fund managers.

Although retail investors dominate the regional stock markets, they have received poor treatment from both fund managers and regulators to date. Encouraging smaller shareholders to enter the market through professionally managed funds will take the financial market industry forward and move away from the disease of chronic day-trading. There have also been calls to discourage international hedge fund managers from investing in regional funds. "I would support that. As a fund manager we don't want an investor who comes in only to leave in a few months and destabilise the fund," says Global's Hameed. "But at the same time we cannot block short- term investors to enter the market directly as they bring liquidity."

It is going to be a crazy ride for the next few months, but the true test of regulators always comes during tough times. And that could ultimately determine which of the Gulf's financial hubs is first among equals.

- The writer is managing editor, Zawya.com

The world may be about to find out if short sellers really are the scoundrels they are accused of being for exacerbating the current financial crisis.

In the past few days, regulators in the United States, Britain, Canada and Germany have imposed unprecedented temporary bans on the short selling of fin-ancial shares as they seek to head off what is threatening to be the worst financial turmoil since the Great Depression.

The ban "will result in exactly the opposite in what they want to achieve," said Doug Kass, founder and president of hedge fund Seabreeze Partners Management, who is also a short seller. "It will scare the longs into selling, exacerbating stock price declines."

Critics say they are interfering with the basic functioning of the markets, including taking away liquidity provided by the shorts, at a time when things are already enormously shaky.

"My concern is that a total ban really does not comport with free market principles and I also think it leads to very potential dislocations in our markets that don't need to have been created this way," said Harvey Pitt, who was the chairman of the SEC when US markets plunged after the September 11, 2001 attacks.

The potential harm, short selling experts say, comes from discouraging shorting overall.

Some short sellers say they don't mind cracking down on the abuses to some extent, such as preventing the spreading of malicious rumours, or tightening up a bit on certain types of naked short selling. But they feel they are being unfairly targeted, especially as they have been actually pretty good at locating overvalued companies.

And with the crackdown on naked short selling, some short sellers now worry a clerical error - such as a broker mistakenly telling them they had stock when they did not - could now land them in court. They wonder how they will prove they were not deceiving their broker.

- Reuters