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The FSA’s ban on the short selling of financial stocks is not the first time the practice has come under fire. Back in 2002, Howard Davies, the then chairman of the FSA, called for greater disclosure to be introduced. Yet at that point he rowed back from an outright ban, defending short selling as “a necessary and desirable underpinning to the liquidity of the London market”.

Now opinion is split over whether the FSA’s move is overhasty or whether it, as Jerome de Lavenere Lussan - managing partner at Laven Partners, asks - represents “a bold and courageous move”.

“These are unprecedented times,” he says, warning the move may not prove popular for investment managers in London and could limit their ability to compete with managers based in other jurisdictions.

The regulator's move is so unpopular, in fact, that questions have been raised over whether hedge funds could actually sue the FSA for losses incurred because of the ban. According to the Alternative Investment Management Association (Aima), the measures are likely to affect risk management and portfolio insurance for all investors, including pension funds, mutual funds and insurance companies.

“For some investors it makes sense to short certain stocks. While some market rumours suggest this may be a malicious practice it is a legitimate investment activity. By imposing an overnight ban the FSA will hurt legitimate investors and possibly some hedge funds,” Mr de Lavenere Lussan adds.

Thomas Becket, director of investment strategy at PSigma Investment Management, says: “There seems to be very little evidence that the short sellers were culpable for the recent collapse in banking shares. The hedge funds and traders have been made scapegoats, when the government, the authorities and, most importantly, the regulators should have been examining more closely their own actions and the catastrophic business plans the management of the banks had been employing.

“These are the people who have contributed in no small part to the economic problems and the deleveraging we are facing.”

A key concern is the immediate contraction in the investment universe. “The recent measures will have particular long-term implications for the small number of equity long/short managers who specialise in financial companies,” explains Andrew Baker, deputy chief executive of Aima. “In the case of the UK, it removes up to 20 per cent of market capitalisation for short sellers.”

It has also curtailed the normal business of exploiting arbitrage opportunities during mergers. Many hedge fund managers, says Chris Rexworthy, director of risk consulting at IMS Consulting, a regulatory compliance consultancy with many hedge fund clients, see the HBOS/Lloyds TSB merger as a lost opportunity. “There are a small number who are angry,” he says. “And they are angry because they are looking at institutions in the market and thinking they legitimately would be able to make a profit by short selling them.”

The question for Mr Rexworthy, who until 18 months ago was head of wholesale supervision at the FSA, is whether the regulator has gone too far. “The US regulator has got it right with its intention to ban naked short selling,” he says. “With naked short selling, you can attack a company and drive prices down, but with covered short selling, you can’t sell more stock than you can actually borrow, so the impact is limited to the available stock.”

The differential between naked and covered short selling is key to the debate. Because naked short sellers – outlawed this month by the US Securities and Exchange Commission – do not actually have to borrow the share before they sell a stock short, it means the potential for mischief making is amplified.

However, PSigma’s Mr Becket contends too much blame has been ascribed to hedge fund managers and short sellers. “When the US banned short selling of certain financials in the summer, it just added to the uncertainty that has afflicted the financial system."

He points out that Lehman Brothers actually went into bankruptcy, with just 2-3 per cent of their shares on loan. “We will become more confident on the outlook for banks when they have addressed and solved their problems, recapitalised and the economic storm eases. This combination would have stopped the short sellers anyway.”

For Mr Rexworthy the blame lies not with short sellers or hedge fund managers, but with global investment banks. “Rather than hedge fund managers being demonised,” he says, “the spotlight should be turned back on the boards of investment banks.”

Hugo Greenhalgh is editor of Investment Adviser