Veritas – Why Europe’s short sale bans will apply, and fail, again

At some point in this crisis, banning of short selling had to happen.

But it did not work when at least 14 regulators worldwide imposed bans in late 2008, and markets kept falling nevertheless.

And there is no reason to think Italian and Spanish markets will react any differently this time.

Both countries today banned short-selling of stocks, amid concerns that their economies would need sovereign, not just bank, bail-outs.

In Madrid the CNMV said its three-month ban will encompass equities or indices, including cash equities transactions, derivatives in regulated markets or OTC derivatives that could create a net short position or increase a previous one.

Italy’s Consob has a one week ban covering banking and insurance shares.

Both will probably fail in the long run.

Italy’s economic problems will last longer than one week, and a seven-day ban will simply store up the ‘short’ demand, for the following week.

Spain’s moratorium is larger, both by remit and length, but Spain’s debt and banking problems will also take longer than the ban lasts, to unwind.

There are numerous shortcomings of shorting bans.

First, they remove one of the main contrarian investors – hedge funds – at the very time that markets most need them – as they are falling.

Second, those hedge funds with relevant short positions already in place keep them on, at all costs, because the ban itself makes the positions instantaneously ‘gold dust’, or a competitive advantage over rivals unable to build stakes. John Paulson, whose hedge funds made most money out of reportable short positions in banks back in late 2008, kept some of his bank positions on for months. There is no reason to think funds will act differently, to Spain and Italy, this time.

Third, the bans shoot the messenger, they do not tackle the underlying problem.

Yes, markets are afraid of contagion, and they therefore short Spain and Italy.

But they are afraid because Eurozone governments have failed to quell their fear via concrete measures to solve the problem. Stopping a legitimate financial activity such as shorting does not solve this ‘fear factor’.

Fourth, the bans demonstrably do not stop prices falling. Investors far larger than short selling hedge funds are typically behind much of the selling pressure. Numerous studies by academics and hedge fund trade body AIMA show this.

And finally, ‘real world companies’ often object to the bans – though some banks and insurers may welcome them.

Spain’s CNMV said in its rationale today its markets were threatening to turn disorderly, and impede normal financial activity. But if you hunt the archives of submissions on previous plans to ban short sales of sovereign CDS since 2008, you find one paper from German carmaker Volkswagen.

It argued against a ban, saying it needed to be able to short sell debt using CDS, to hedge its trading activities with foreign nations. Ban it, and one risks “affect[ing] the normal development of financial activity”, to borrow CNMV’s phrase.

Arguably a more important immediate question is, will the two watchdogs that acted today now be joined by more, as happened in September 2008? If Eurozone leaders are keen to be seen as acting in unison, this is likely.

Also, under European proposals passed in March, from next year the European Securities and Markets Authority, the pan-European regulation co-ordinator, will have emergency powers to impose short-selling bans of some instruments covered by the curbs announced today.

Markets will watch keenly for any comment from ESMA figures regarding the current situation.

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