Hedge funds brace for more short-selling bans

* Funds wary as regulators mull extension to shorting ban

* Extension could hit merger arbs, long-short equity

By Laurence Fletcher

LONDON, Aug 25 (Reuters) - Hedge funds, wary of more intervention by European stock market regulators, are being forced to rethink investment strategies as authorities decide whether to extend short-selling bans.

Managers and the banks that help them structure their trades say they are confused by some aspects of the bans, which were brought in by four countries earlier this month to curb wild swings in stock markets, particularly financial shares.

The measures have so far failed to prevent falls in financial stocks, which are heavily exposed to the euro zone debt crisis.

Some managers are thinking twice before placing trades in case the curbs on short-selling financial stocks -- which are set to lapse this week in Italy, France and Spain -- are renewed or extended to other countries. The ban in Belgium is indefinite.

Italian newspaper Il Messaggero reported on Thursday that regulators are planning to extend the ban for another month until the end of September.

"It's a nightmare for clients," said one prime broking executive, who spoke on condition of anonymity.

"Right now, banks are in internal dialogue to try to figure out what it means. Can you short an index if it's got financial names in? Each bank is reaching a different conclusion (about what percentage is permissible)."

Short-selling is a common way for hedge funds to bet on falling share prices, whereby traders borrow stocks to sell them on to later scoop them up at a lower price.

Long-short equity hedge funds, which often match a bet on a rising stock price with a bet on a falling stock price in the same sector, and event-driven funds, which hedge their bets on events such as takeover, are among funds where the potential impact is greatest.

Meanwhile, "black box" computer-driven trading programmes, which can quickly buy and sell positions and which short-sell stocks to hedge their portfolios, may also have to adapt their models.

CONFUSION

Regulators are set to announce their decision on whether or not to extend the ban. Spain has already said it may extend the ban if necessary, while European Securities and Markets Authority chairman Steven Maijoor has said "we cannot rule out" bans in other countries.

However, even the chance of the ban being extended could make hedge fund managers reconsider certain bets.

For instance, investors betting on a takeover deal in the banking sector -- a trade in which a fund typically buys shares in the target and shorts the company making the acquisition -- could be wrong-footed if a ban is reprised.

"The regulations change and can change overnight," said Sam Morland, founding partner and CIO at $70 million hedge fund OVS Capital. "If the ban was lifted and there was an all-share merger ... in the bank sector... you might think 'they might reintroduce the ban during the middle of the deal'.

Managers are wary that markets are entering a new environment in which -- as in the depths of the 2008 credit crisis when the UK and U.S. imposed shorting bans -- regulators act in an attempt to reduce market volatility.

The bans have come as French President Nicolas Sarkozy and German Chancellor Angela Merkel propose plans for a so-called Tobin tax on financial transactions -- a move that would likely affect where investors put their money.

"It (the ban) creates more volatility, not less," Cairn Capital chief investment strategist Graham Neilson told Reuters. "But ultimately (the) investment rules of engagement are changing where this and the newly announced Tobin tax are all forms of capital control.

"The ban creates confusion and reduces the ability to risk manage portfolios meaning the only way out is to sell the underlying long bond position."

Since Aug. 12, the Stoxx European banking index is down 7.5 percent after hitting a low for the year four days after the bans were introduced. The broader European market is down about 3 percent. (Reporting by Laurence Fletcher. Editing by Chris Vellacott and Erica Billingham)