During October 2008 the US and UK regulators temporally banned short sales on certain
financial stocks. This controversial topic has become relevant again recently when the
German Government banned naked short selling on euro-zone government bonds, Credit Default Swaps (“CDS’s”) and 10 financial stocks on 18 May 2010. Subsequently the European Parliament’s Economic and Monetary Affairs Committee proposed a total ban on naked short selling and argued that the European Securities and Markets Authority, a proposed pan-EU body, should be given powers to restrict all forms of short selling “in exceptional circumstances or in order to ensure the stability and integrity of the financial system”.
Short-selling in general involves traders profiting from falling share/asset prices. The technique works when investors sell shares that they do not own, hoping the price will fall. The aim is then to buy back the asset at a lower price and as such pocketing the difference between the higher sale price and the cheaper purchase price.
There are basically two forms of short selling:
- Conventionally, the trader will “borrow” securities from a current shareholder, typically a bank or prime broker, agreeing to return them on demand. The seller delivers these shares to a buyer, who takes full ownership and likely does not know that he is participating in a short sale. When the seller wants to “unwind” the position, he buys back equivalent shares in the market and returns them to the
lender. It is not possible to sell more stock than there is in issue.
- Naked short selling is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed as is done in a conventional short sale. When the seller does not obtain the shares within the required time frame, the result is known as “fail-to-deliver”. However, the transaction generally remains open until the shares are acquired by the seller or the seller’s broker, allowing a trade to occur when the order is filled. Naked short selling therefore creates the potential to sell more of a stock than there is in issue.
3. How does naked short selling on CDS contracts work?
The FT (20 May 2010) offered the following explanation:
“Why is a naked CDS different from a naked short sale of bonds and stocks? Buying a credit default swap in effect buys insurance against the risk of a default by either a company or country. This is essentially a short sale, since the holder profits from the contract if the entity does default. Even before that happens, the CDS holder benefits if the outlook for the entity deteriorates, because the insurance premium for that default risk will rise and the holder can profit by selling the insurance and closing out their trade. Some investors holding debt issued by an entity, buy credit insurance to protect their portfolios from such a risk, but most buying comes from investors who simply want to express a negative bet. As such, buying credit protection without owning any of the entity’s debt is a “naked short bet.”
Thus the writers (usually investment banks) of CDS contracts will either have to warehouse the risk of the underlying credit risk (like AIG did until 2006) or hedge themselves with other CDS writers (other investment banks) or sell the underlying bond short (either naked or conventionally).
4. Why has it become a concern?
In times of severe financial turmoil when prices of shares and bonds are under pressure, speculators tend to enter the market. They may inflame the situation by building up short positions in already distressed securities, depressing prices even further. Recent examples are the Asian crisis in 1998, the Global Financial crisis during 2008 and lately the Greek Bond crisis.
- Example 1: Bear Stearns
The collapse of Bear Stearns, Lehman Brothers and AIG as well as market anxiety over Morgan Stanley and Goldman Sachs in 2008 raised serious concerns regarding the effect of short selling in the listed equity markets. Many market commentators blamed malicious naked short selling as the main cause of panic in the sell down of investment banking shares. As an example – it is alleged that certain hedge funds took naked short positions in Bear Stearns and then started false rumours that Bear was struggling to fund itself.
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