The German ban may have a stifling effect on the economy
Naked short selling might sound like a nudist flogging Bermudas in a busy marketplace, but the reality is just as bizarre. The practice allows investors to sell shares they do not own and have not borrowed for the duration of the trade. A salesman on eBay engaging in such an antic might well get arrested.
But in the world of finance everything is possible. That politicians (and the electorate) want to introduce regulations to prevent a recurrence of a financial market meltdown is inevitable. The problem is when new rules are ill-thought out, rushed through as law and (ultimately) create their own unintended consequences.
In May the German authorities announced plans to ban short selling of certain equities, government bonds and credit default swaps. (Obviously, it was a mere coincidence that this was imposed shortly before the German parliament was scheduled to vote on the country’s contribution to the €750 bn ($918 bn) rescue plan for the beleaguered Eurozone.)
The move was announced unilaterally and without consultation with other G20 countries. Leaving aside the difficulties of imposing such a ban in an international marketplace, blaming naked short selling for the financial market crisis is a bit like attributing global warming to the flatulent teenager on Two and a half men.
Certainly, naked short selling has its critics. Between January 2007 and June 2008, more than 5,000 complaints were lodged with the SEC, alleging the practice had manipulated stock prices. Affected firms argue it creates phantom stocks, as those buying the uncovered positions believe themselves the shares’ rightful owners.
But whether it played a huge role in the financial crisis is debatable. The research paper ‘Naked short selling: the emperor’s new clothes?’ by academics at the University of Oklahoma found that, with one exception in June 2008, naked short selling in Bear Sterns, Lehman Brothers, Merrill Lynch and AIG was too low to lead to significant stock distortions.
Indeed, naked shorting became ‘abnormally heavy’ only after dramatic stock price distortions, indicating sellers were not responsible for triggering price declines but were, rather, responding to information in the public domain. In 2008, when the SEC banned naked short selling of 19 financial securities between July 15 and August 12, the academics found significantly higher absolute pricing errors and lower trading volumes. This was attributed to a lack of price discovery and reduced liquidity as a direct result of the ban.
Such research, plus the sell-off that ricocheted through financial markets following the ban’s announcement, should trigger alarm bells in the offices of Germany’s financial regulators. But their biggest concern should be the ban’s stifling effect on the bond markets’ recovery: total weekly issuance in euro-denominated bond markets in the aftermath of the announcement slumped to its lowest level in a year. European banks must refinance significant debts pretty soon; if the markets are shut, selling Bermudas in the buff may become a very real career choice for some.
