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Banning Short Selling Is an Act of Desperation

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In late May, Germany banned naked short selling of eurozone government bonds and shares in 10 leading German financial institutions. It struck me as futile attempt to prevent the inevitable.

In a normal short sale, the seller borrows shares that he or she doesn't own from a broker, and sells them to profit from an anticipated fall in the prices. After the trade is over, the seller buys them back and returns them to the rightful owner but keeps the difference in price. If the buyback price was lower, the person taking the short registers a profit; if it's higher, he or she incurs a loss.

So how does Germany's ban really affect the short sale?

Well, most of the stocks trade in the U.S., which of course is not covered by German regulators. One of them, Deutsche Bank (NYSE: DB  ) , is listed on the NYSE, while others trade over the counter as American depositary receipts. So you can still sell the stocks short here in America -- or in London, for that matter.

CDSes are a different problem
It looks as if the target of the German ban was more the eurozone government bonds than the 10 stocks. Just as with stocks, you can sell bonds short electronically before locating them if you are a market maker. The German ban also covers credit default swaps linked to euro government bonds -- you cannot buy a CDS if you don't own any bonds. If you do own the bonds, you can buy CDS protection in Germany.

I'm not sure about banning CDSes. I'm all for listing them on exchanges, though, since the clearinghouse effect removes the ripples from the financial system that are caused by failing counterparties. It's easy to blame a CDS contract for the mess, but did CDS traders falsify Greek economic statistics, or create the massive Irish and Spanish real estate bubbles and the equally large banking losses that followed?

What happened the last time we had a short-selling ban
A much larger global short-sale ban in 2008 did absolutely nothing to stop the slide of nearly insolvent financials. If the operating company whose stock is being banned from shorting is in bad shape, the stock will decline, with or without short selling. Citigroup (NYSE: C  ) is a good example for a major financial that was terribly mismanaged and declined to less than $1 in March 2009; no short-selling ban could prevent that. JPMorgan Chase (NYSE: JPM  ) is an example of a major financial that's well managed and that weathered the storm quite successfully, even with aggressive short selling.

The short ratio -- the metric that measures how aggressive short selling in a security is -- has declined a lot more aggressively for Citigroup compared to JPMorgan Chase, yet the stock trades near $4, or about $50 below an all-time high, because of huge dilution resulting from the government bailout.

The U.S. experience clearly indicates that no short-selling ban can save an incompetent bank, whether it is German or domiciled in the United States. The same goes for banning CDSes. The CDS traders are not to blame; the PIIGS governments' fiscal mismanagement is.

More on the Europe issues:

Fool contributor Ivan Martchev owns no shares in any of the companies in this story. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy. 

Read/Post Comments (4) | Recommend This Article (3)

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  • Report this Comment On June 18, 2010, at 10:53 AM, Bot1 wrote:

    Maybe desperation, but on principle I am not a big short selling fan for a number of reasons.

    No matter what people say, ALL short selling disrupts normal supply and demand by creating new counterfeit shares (whether the shares are borrowed or not).

    The idea that short selling helps in price discovery is a minomer. Most short selling by market makers defeats price discovery by filling the order at the current price and not letting supply and demand determine price.

    Also those who see short selling as a way to bet against the current price are just admitting that common stock shares are casino bets and not investments in the company.

  • Report this Comment On June 19, 2010, at 10:32 AM, cmfhousel wrote:

    I generally agree, but your examples of Citi and JPM don't really hold. The short sale ban was from Sep. 19 to Oct. 8, 2009. During that time, most bank stocks either gained value or were mostly flat. Citi didn't hit $1.00 until March 2009 -- five months after the ban ended. From the end of the ban until the low in March, Citi's stock fell 93%.

    But I agree that banning is pretty much useless though. Here's a good paper on it.

  • Report this Comment On June 19, 2010, at 1:16 PM, TMayea wrote:

    This article makes no sense at all! Starting with paragraph 1, NAKED short selling. After that, no mention on NAKED short selling(except for CDS's). What is this article about? Short selling or NAKED short selling? Two very different topics.

  • Report this Comment On June 25, 2010, at 1:06 PM, ivanmartchev wrote:

    Sorry, had to cut short--no pun intended--the naked short-selling choice in the matter

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