The Naked Truth (about short-selling)

28th May 2010

Naked short-selling may sound like fun, but European regulators take a dim view of the practice.

It means that speculators can go short a share that they do not own and have not borrowed.

Put like that, it sounds ludicrous, encompassing the worst excesses of casino capitalism, but the battle lines are firmly drawn between those (usually hedge funds) who believe it is a legitimate hedging technique and those (usually regulators) who believe it is speculative and distorts normal supply and demand patterns.

The European Parliament's Economic and Monetary Affairs Committee has now proposed a complete ban on naked short-selling as part of its Alternative Investment Fund Managers Directive (see here for a summary of the latest proposals for the Directive).

In a recent trip to London Jean Paul Gauzès, the French MEP responsible for putting the bill to the European parliament dismissed the practice as speculation with no legitimate place in financial markets. 

The Committee also proposed that a new pan-European authority be given powers to restrict all types of short-selling when the stability of the financial system is under threat.

It is easy to see this as the European Union authorities being high-handed and bureaucratic – scouting round for someone to blame for the financial crisis.

There is some truth in this. Certainly the German Chancellor Angela Merkel's decision to ban naked short-selling in certain instruments in an attempt to calm bond markets has attracted some derision.

Principally, the condemnation visited on governments and regulators over short-selling centres on the extent to which it is an effective tool to calm markets.

Restrictions on short-selling have routinely been employed by regulators historically at times of market stress and have generally failed to prevent further busts.

This time – far from calming equity and bond markets – it has led to greater volatility, largely because markets don't like governments interfering in their operations and fear what may be coming next.  

But this leaves out a couple of important points.

Firstly, the US – that beacon of free-wheeling capitalism – has already banned naked short-selling.

The introduction did cause a blip in markets, as it has now in Europe, but the authorities there believed that it created volatility.

This article on CNN Money gives the best explanation on why that might be.

It quotes Sharyn O'Halloran, professor of political economy at Columbia University saying: "Until the short-seller has bonds to deliver, the buyer doesn't have to pay.

"But by showing that a sale has taken place even though the goods haven't actually been transferred, a naked short-sale artificially drives a stock's price down to a level that's not reflective of true supply and demand."

The ban has attracted much confusion as this thread on The Motley Fool demonstrates.

First there is confusion between naked short-selling and unhedged short-selling.

Then many people have suggested that the German government has banned short-selling per se.

It may do in the future at times of market stress – this is what is proposed in the AIFM Directive – but it is not what has happened to date.

While a case can be made for short-selling increasing the efficiency of markets, it is difficult to make such a compelling case for naked short-selling.

When a lot of investors want to sell-out at one time, short-sellers can act as a natural cushion for a share price, but it is difficult to argue that markets need naked short-sellers as well.

Bob342 on the Motley Fool has a stab: "Maybe the company borrows from client B. The next day that client wants to sell their stock, should they be prevented from doing so because the stock has been lent out (assuming it's a hard-to-borrow stock)?

"The new rules would prevent that, hurting the regular long investor who wants to sell, or eventually reducing the efficiency and profits of the broker which would result in higher fees."

Hmmm.

More convincing is this piece in The FT – which shows that banks tend to use naked short selling to protect their loan exposure to companies in troubled countries.

It also shows the tiny influence that naked short selling exerts on the overall market.

The exception is in illiquid instruments, where it can have a disproportionate effect.

Naked short-selling may be a bit unsavoury. In the new austere climate it smacks of ruthless profiteering and, frankly, markets are volatile enough on their own.

However, it is difficult not to conclude that this is using a sledgehammer to crack a nut.

It may add to the volatility of markets, it is certainly not what originally created it.

But the politicians need to be seen to act and this is their chosen approach.

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