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Is the ban on naked short selling going to destroy the Euro, or is something else lurking beneath the shadows?  This article is an edited version that originally appeared here.

Germany recently banned naked shorting of government bonds and select financial firms.  According to the Guardian:

   

The clampdown covers sovereign bonds issued by eurozone countries, credit default swaps (CDS) on those bonds, and the shares of 10 of Germany’s biggest financial institutions including Deutsche Bank and Commerzbank. (Link)

For those who don’t know what either 1) short selling or 2) naked short selling is, here is a quick primer.

  1. A standard short is when a seller thinks that a bond is artificially higher than it should be.  They will borrow the bond, sell it to a buyer at the current market value, and then buy the bond back after the market readjusts.  The seller then keeps the difference and returns the bond to the original owner.
  2. Naked short selling is a little bit different.  At the most basic level  the seller will sell the bond to the buyer with out actually having the bond in their possession.  Naked shorts basically artificially drive down the price of a stock.

Just on face value naked short selling sounds completely and utterly insane.  If I took money from my neighbor in exchange for a car and I didn’t have possession or anyway to gain possession of the car most people would classify me as a fraud, but yet the rules for high finance seem to be different. Mark Cuban believes that naked short selling is probably a bad thing, but that it isn’t going to ruin most well capitalized companies and is probably rare.

 

To pull a page from the CSI tv shows, Naked Shorting leaves "markers" that would pose red flags in the normal course of corporate business.

   Companies take shareholder votes on any number of issues. In the course of counting these votes, which across the thousands of public companies, probably happens 100k times a year, I would think that somewhere across those votes, across the last however many years, some well known company would have had to report to their shareholders and possibly the authorities that they received more votes than there were shares outstanding ...

   ...If naked shortselling is rampant, and the volumes far greater than we could ever imagine due to the lack of enforcement, then at some point, some big fund or shareholder , with an interest in corporate governance would have picked up a significant volume of "naked shares", wouldnt they ? That fund is going to want to vote those shares. Somewhere along the line, if the problem were rampant (my new favorite word), a red flag would have popped up at some big public company that could have been traced to naked shorting...

   ...Whether the SEC does or doesn't make enough of an effort to enforce the rules of Naked Shorting, a bigger question is whether or not its enough of an issue in US Markets for them to redirect resources. I say no. Its not a problem in the US Markets.

So in essence Cuban is saying that there is little evidence that Naked Short selling is rampant in the market.  Opponents of this legislation seem to disagree and claim that the move could backfire on the Eurozone.

   Atsushi Mizuno, a former board member of the Bank of Japan, agreed that the move could backfire. If investors cannot hedge their exposure to Europe by naked short-selling of bonds and CDS contracts, then they may simply concentrate on selling the euro instead.

Personally I think this is a somewhat short sided line of thinking  People should sell the Euro because the entire monetary system is essentially a house of cards.  The Union expanded to quickly for its own good, allowing countries who did not meet specific financial requirements to join (Greece) while disallowing those who did (Turkey) for political purposes.  The Euro was always somewhat of a pipe dream.  I distinctly remember my Econ 110 Professor predicting the decline claiming, "Germany has a tough enough time passing a bailout for Eastern Germany, do you really think they are going to want to bail out Ireland?"  The only thing he got wrong was the country, he should have said Greece.

Essentially the European Union is ignoring it’s own standards for admission and governance. This is the reason why you should short the Euro, not the sudden illegality of a dubious financial instrument.  Let us take a look at one area, Government Debt (% of GDP)

       The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.  – EU

Of the 40 percent of the 10 EU countries receiving AAA would not currently qualify for admission into the European Union.  Only Sweden, Spain, Netherlands, Luxembourg, Finland and Denmark would- None of which are large economies. For a sophisticated break down click here.

For the AA Bonds it becomes even more dubious.  Belgium and Italy are unmitigated debt disasters and Portugal looks like they are next for a Greece like financial engineering crisis.  The only EU countries in this tranche that are in solid fiscal shape are surprisingly the new admits: Slovenia and Cyprus. For a sophisticated break down click here.

For the A countries Malta and Greece (Obviously) are in rough shape.  While the former Checkoslovakian countries have their finances in order.  For a sophisticated break down click here.

Essentially, please do not blame the outlawing of selling bonds that you do not own as the reason for the decline of the Euro.  Let’s look at the underlying problem.  10 of the 20 A and above EU bonds would not meet the criteria for Euro zone convergence.  The long term debt situation and political strife are the more logical components.

Edit 5/20/10 - I just wanted to clarify something.  Short selling itself is not a bad thing.  When a stock is artifically inflated short selling adjusts the market.

For the complete article including graphs and pictures click here

Originally posted to ibwip on Wed May 19, 2010 at 08:39 PM PDT.

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