Banning Short Sales. The Insanity Moves to Germany

It's happened again. Short sellers get the blame. Recently Germany's prime minister, acting alone and without support from any of her Euro zone allies, enacted a ban on the naked short selling of specific
euro area debt and of naked purchases of CDS (credit default swaps) on sovereign debt. These bans apply only to trades made on the German markets, and traders can get short these items elsewhere.



We'd like to point out that option traders can take short positions in these securities using option strategies. The simplest idea is to sell synthetic stock. That means buying one put option and selling one call option – with the same expiration date and strike price. That combination is equivalent to being short 100 shares of stock. Unless the ban is extended to the option markets, these short sale bans don't ban anything.  The amazing part to me is that people who favor banning short sales don't recognize that options can be used as a stock substitute.  

Options are versatile investment tools and can be used by investors to accomplish a variety of investment needs. That not only includes hedging (reducing risk) but also synthetically selling short.

What is short selling?

Selling short is the sale of an asset that is not owned by the seller.  The idea is for the seller to borrow the asset from someone who is willing to lend it (for a fee), sell it, and then repurchase that asset at a later date. The short seller believes the asset is over-priced and that he/she will be able to buy it back at a lower price. At that time the asset is returned to the person (or institution) from whom it was borrowed.

Naked short selling occurs when the short seller neglects to borrow the asset and sells it anyway.  That's against the law, but it's an easy loophole.  Brokers don't enforce this rule on their favored clients.

Short selling has been widely used in stock markets all over the world as a legitimate method for betting stock prices will decline. The rationale for banning short sales is that it alleviates selling pressure on the shares of certain assets – thereby making it less likely those shares will get pummeled by other market participants.

It's easy to understand the idea behind these short sale bans. In the US, one was enacted as recently as September, 2008. Here is part of the official press release from the SEC (Securities & Exchange Commission):


Washington, D.C., Sept. 19, 2008 — The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence.


They don't make any attempt to hide it. The short sale ban is issued to 'strengthen investor confidence.' No doubt about it, anything and everything seems to be fair when the goal is higher stock prices. Don't misunderstand us. We enjoy a bullish stock market as well as anyone, but the market has to be a fair playing field. We all must understand that markets rise and markets fall and government intervention is not the answer.[Intervention is not the same as regulation]

Let's hope that the SEC has learned something in the year and one half since they issued that ban.

Has anyone ever seen any attempt to limit a run-away bull market? Of course not. Bull markets are good – isn't that the theory? The SEC apparently believes that boosting confidence and encouraging investors to jump onto the bullish bandwagon is good for America. The fact that the bubble bursts and huge numbers of investors are hurt does not seem to faze them.


Blame the bears?

Instead of blaming over-enthusiasm by the bulls; instead of placing some restrictions on the rate at which markets can rise, instead of doing what they can to prevent bubbles from forming, the SEC, and now the German government, take action by banning the practice of short selling specific securities related to the financial markets. In effect this places the blame on those 'nasty' short sellers.

They blame short sellers for the fact that markets were over heated and over extended and that if only those short sellers would go away, the bull markets would last forever. Never blame the bulls for building a bubble and always blame the bears for ending a bubble. It just doesn't seem right.

And these are our government leaders who make these decisions. How does that instill confidence?

Everyone believes that rising markets are nirvana. When markets rise, people feel wealthy, spend money, and invest in business as prosperity reigns. When markets fall, consumers feel less wealthy – and that's true even when any stock market investments are tucked away in a retirement account and won't be needed for decades. Under those conditions, optimism fades, spending and new business start-ups are reduced and that leads to unpleasant results on Main Street. The current high unemployment rates are a result of the lack of confidence on the part of those who would ordinarily help the markets grow.

As we see it, that means the banks. They do not lend money to those who want to grow the economy. No loans for business start-ups or expansion. No loans for those who want to hire others. World governments rescued banks when they faced bankruptcy and the banks feel that there is no need to return the favor. No need to provide benefits to the taxpayers who bailed them out. No effort to build wealth – with the obvious exception of their own individual wealth.

We are not alone. From the May 19, 2010 Wall Street Journal:

"We've been here before—and the parallels are hardly reassuring. Germany's decision to ban naked short-selling of euro-area government bonds, sovereign credit default swaps and 10 German financial stocks until March 2011 is a desperate move that comes too late to prevent a deepening of the euro-zone crisis—and may make it worse. "

There is something wrong with this system. Banning short sales, even when the number of issues banned is small, is not the solution.


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6 Responses to Banning Short Sales. The Insanity Moves to Germany

  1. Michael James 05/24/2010 at 8:16 PM #

    I’m no expert when it comes to short sales, but I’ve wondered about potential problems with naked short selling. If big price moves lead to inadequate collateral and the short seller gets wiped out, who is on the hook for the lost money? There are more stock owners than there are real shares. Someone has to eat this loss. In covered short selling, it makes sense that whoever lent their shares would take the loss, but in the naked short selling case I’m not sure who loses.

  2. Mark Wolfinger 05/24/2010 at 10:16 PM #

    I’m almost certain it’s the short seller’s broker. After all, they are the folks who allowed the NAKED short sale.
    IMHO, it’s always the broker who takes the loss – assuming that the cash cannot be wrung out of the now broke customer.
    That’s why they have margin accounts, issue margin calls, and keep an eye on customer’s risk. If the customer cannot make good on debt, the broker eats it.
    I don’t see any difference between a long or a short who gets wiped out.

  3. Michael James 05/25/2010 at 3:06 AM #

    I guess there is still too much I don’t understand about the mechanics of investing, but I was thinking of a situation where the “customer” is actually a large financial institution that chooses to make a very large bet in the form of a naked short sale. Would it have to meet the same sort of collateral requirements as individual investors? Would it serve as its own broker? I guess I’m trying to explore the possibility of naked short selling leading to large losses where it isn’t obvious who should soak up those losses once the institution making the large bet has failed.

  4. Mark Wolfinger 05/25/2010 at 7:32 AM #

    Yes, the large institution is supposed to meet the same requirements. The question is who is going to force them to do so? Naked short selling was fairly common. I have no idea whether that has been tightened.
    I suppose (I don’t truly know) it does serve as its own broker, but someone, somewhere is supposed to enforce the rules.
    You raise a good point. I hope the answer is available to a bit of research. I’ll get back to you.

  5. Michael James 05/25/2010 at 1:15 PM #

    Thanks for the information, Mark. I think short sellers serve an important function in financial markets. The main concern I have is that someone should be adequately compensated for the risk that the borrowed securities can’t be returned. When the party lending the securities understands this risk and puts a price on it, then all is well. If there is a scenario that allows a short seller to push this risk onto someone else without compensating them, then there is a problem. Without understanding much about some of the mechanics of short selling, I had assumed that the bans on naked short selling had something to do with the uncompensated risk of not being able to make good on the promise of returning the shorted securities.

  6. Mark Wolfinger 05/25/2010 at 1:32 PM #

    Borrowed securities can ALWAYS be returned. For example, If I borrow them in size, and then go belly-up, my broker will buy those securities in the open market to return them.
    Then the broker tries to get the money from me.
    The issue is whether the broker gets stuck with the bill. But the situation you raise here is not an issue. The short stock is repurchased.
    “Adequately” compensated? They are compensated to the extent that they are paid interest when lending the shares. Obviously that not sufficient to cover a big loss, but this may be similar to anyone who buys junk bonds. High return with some risk of losing it all.
    But, as I said, the lender of shares should never be at risk. I suppose if my broker gets demolished on the same day I do and they also go belly-up, then there is no one to make the security lender whole. Perhaps SIPC can help, but their protection is limited. I don’t know if you have something similar to the Securities Investor Protection Corporation in Canada.
    I’m sure there are good reasons stated in the rule that bans naked short selling. Your concern may be on that list. I have not yet been able to verify.
    I just called the margin department of a big broker. They see it as I do. It’s my loss and if the broker cannot recover the loss from me, they eat it.
    The shares would be repurchased and returned to the lender. Thus, that person is protected. But I still have no idea what happens if the broker goes broke.
    I hope that helps.
    Best regards,