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Naked short selling: All shout, no trousers

A naked short seller who is about to clean up

When Germany decided to ban the naked short selling of European government bonds, credit default swaps and the top ten German financial institutions in response to the escalating Eurozone crisis, it was following a long tradition of indignant bureaucrats.

Regulators love to blame short sellers for exacerbating market turmoil, if not for downright causing it.

Most politicians are technocrats. They truly believe that clocking up 2.5% GDP plus inflation – year in, year out – is a credible aim for a market. Why all this Sturm und Drang? No more boom and bust!

By definition, politicians also like to score political points – such points are free, and the voters love them. Down, evil short-sellers, down!

The Americans already banned naked short selling

Still, Germany’s ban on naked short selling is hardly outrageous if you consider that the U.S. introduced such controls in the banking crisis in 2008, and never rescinded them.

Why should Europe alone face the locust hordes?

Yet just as Lehman Brothers’ collapse wasn’t caused by short sellers (they might have finished it off, like hyenas tearing apart a sick animal) so the gyrations in European securities haven’t arisen in a vacuum.

Weaker European countries have borrowed too much, and lived high on the hog for too long. Germany has been too stingy. Something had to give.

That said, one can understand the politicians’ frustration. I heard last week that French banks, having just been underwritten by the enormous Euro-aid package, were among the first to begin shorting the Euro in response!

I guess asking traders not to take profitable trades would be like asking a baker not to bake after you’ve paid him insurance for burning down his bakery.

Naked short selling versus everyday short selling

If you’re going to ban short selling, then it’s certainly the naked form that’s the most dubious.

Short selling means borrowing a stock or other security from someone, selling it, and hopefully buying it back more cheaply later. Like this, you turn a profit from the price difference (after paying interest to whoever you borrowed the stock from). But if the stock’s price rises after you sell it, you lose money.

Naked short selling differs in that you never actually borrow – or even arrange or intend to borrow – the security you sell short. In theory, this could mean that it’s possible to drive down the price of a security beyond the normal relationship of supply and demand for the underlying asset. That said, someone is still taking a real money risk in wagering the price will fall, so in that sense it still represents real price information in the market.

There’s much dispute amongst market watchers as to whether naked short selling can unduly disrupt markets, or even whether it can be effectively banned. I don’t profess to have a clue, let alone an expert opinion.

What’s clear though is in the short-term, actions such as banning naked short selling by the authorities can ironically stoke more fear, rather than calm the markets.

A traders’ immediate reaction to any sudden change will always be: “What don’t I know now, and what’s being hidden from me?”

And that’s not a recipe for a stable market.

Further reading on naked short selling

Okay, about that picture above… He’s a naked short seller who is going to clean up. Geddit? Sorry!

{ 4 comments… add one }
  • 1 Evan May 20, 2010, 3:56 am

    Maybe you can ehlp me out, with something that has been bothering me but I never bothered to look up with naked short selling (or shorting in general). What happens if everything goes to bloody hell for the short seller (even an American can use the word bloody lol) and the particular stock sky rockets AND the investor doesn’t have the money?

    Does the brokerage house just become a creditor to the investor? What if it is an investment corporation with limited liability? Can’t a Corp/LLC just short the hell out of a stock in hopes to hit a home run and then just fold up if they are wrong?

    Things may be different in US from Uk but some help would be great.
    .-= Evan on: Using Ellis Island Records to Find Relatives for Free =-.

  • 2 Lemondy May 20, 2010, 9:25 am

    Evan, an investor must hold “margin” (collateral) at the broker to go short. If the short moves against you to approach the point where the collateral would not be sufficient to cover the loss, the broker makes a margin call. You’re required to stump up more cash, or else the short is forcibly closed on you.

    Brokers will close you out rather than become your creditor; you hear stories in the news sometimes where they rely on an apparently high-net-worth trader being “good for the cash” and in fact that high-net-worth has a negative net-worth and it all ends up in court.

  • 3 OldPro May 20, 2010, 10:53 am

    Naked short selling when used by rampant vulture squids… all these animals we have to mix up these days!… thats obviously a bad thing but in general theres naked shorting… or synthetic shorting… is a useful part of providing liquidity to a market.

    Frnstance.. Say you and a mob of other long-holders want to sell your shares at the same time… the market maker can either enable the price to gap down until some bottom fishers / bots these days I suppose come out of the woodwork, or he/it can create/sell synthetic shorts to keep the market moving and liquid.

    Also take out mechanisms for shorting and the hedgies won’t go as long – clue is in the name, they need to hedge! Again, less liquidity.

    None of which is to say Herr Merkel wasnt right to ban naked short selling if she anticipates/knows about speculative attacks…which as you say is one reason why the market went headless yesterday I’m sure!

  • 4 Aury (Thunderdrake) May 27, 2010, 8:36 pm

    HAAAAA! Bloody beaut! The naked short man. That’s the best visual pun I’ve ever seen in a blog all week long!

    I don’t think there’s a more speculative gamble someone can take than a naked short. At least with naked calls, the losses can be limited.

    I don’t have much of a problem with people making naked shorts individually. But doing it for such massive institutions is flat out asking for trouble. I can’t think of a better way to completely shift a country or institution’s entire economic climate in a month than naked shorts.

    At the same time, not only are all these companies completely off the wazoo with such naked shorts (Why not cover, at the very least?) But now there’s all this government intervention trying to pull all this woll on speculative damage.

    Naked shorting damage is one thing. let the booms and busts happens.
    But naked shorting damage with government intervention is nothing short of potentially disastrous. You can only suppress the free market so far before prices flail.
    .-= Aury (Thunderdrake) on: Hoarding Dragon Basics – The Stock Market =-.

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