The German financial regulator announced a ban on naked short selling of government debt certificates, shares of some financial companies and some CDS. The ban is effective for one year. Regulators globally ought to join the German move and should also assess the role naked shorting plays in distorting financial markets, a process that is essentially akin to criminal counterfeiting of securities.
Several other people have posted on naked short selling (you can find those diaries by searching "naked short"). Much of the discussion in the mainstream press has focused on naked short selling of stock; the German policy is significant and new because it temporarily bans naked short selling of government bonds, a step that regulators did not take during the depths of the financial crisis and, second, the global bond market is significantly larger than the global equity markets
Most developed countries allow naked shorting of bonds. Of note, South Korea recently allowed the practice so that its sovereign bonds could be included in a Citigroup World Government Bond Index.
Just to be clear, and to avoid the hyperventilators' version of events from spreading, the Germans are not banning short selling, which serves a legitimate purpose. In theory, when you short sell an asset, you borrow it for a fee from someone who owns it, sell it and deliver it to the buyer upon settlement. The short seller later buys the asset back in the open market, pocketing the difference between the original (hopefully higher) sale price and his buy-in price (hopefully lower), and returns the asset to the lending party. With naked short selling, the borrowing never takes place causing what is known in the system as a Fail-to-Deliver and the buyer receiving an account notation akin to an IOU. The Germans are banning naked short selling in a long overdue policy because it is another of Wall Street's nefarious, obscure practices that enables financial players to siphon money from the system while damaging the security issuers and security holders. Naked short selling does not create value; it destroys it - by allowing Wall Street to create phantom shares and bonds.
Overstock.com CEO Patrick Byrne has been in a decade long battle over naked short selling in his company's shares. He has been labeled a wing nut by many in the media and by so-called "grown up" financial analysts that usually throw up the straw man argument that short selling facilitates market liquidity. Well, yes it does, but the debate is over naked short selling. Details please. The other straw man argument that naked shorting defenders put up is that the companies they shorted got into trouble not because of the shorts but because of bad management. That is true in many cases, but it is beside the point that naked shorting may just be coincidental with a company (government) in financial distress - the central concern is the counterfeiting of securities that results in the financial sector siphoning money from the real economy.
The nefarious aspect of naked short selling is that it enables unlimited short sales. There have been instances where aggregate short sales outstanding have exceeded the number of shares outstanding (or floating). Understand this very carefully: naked short selling enables the financial crowd to create fictitious shares (bonds/other financial assets). This is very useful when you are engaged in pounding the crap out of a public company (or other security issuer) that you think is overvalued.....if your initial short sales do not bring the share (bond, etc.) price down no problem: just go presto and you have more shares to sell into the market. Repeat as needed. Clearly the short seller has the security issuer over a barrel in a rigged casino game, since he is able to sell securities he does not own and neither does he have to borrow them (no fees) and the clearing system does not require he deliver them for trade settlement.
In any reasonably regulated market there have to be two key restrictions on short selling:
(1) the short seller must be required to actually borrow the stock (and pay a fee to the borrower) and deliver it upon settlement to the buyer.
- aggregate short sales must have an upper cap that is the share (bond/other asset) float.
For years Wall Street firms and regulators have denied there is any problem with naked short selling and the inherently corrupt trade settlement and clearing systems. However, sustained pressure by a few lone voices finally lead to the SEC passing Reg Sho, which increasingly restricted naked short sales of stocks. Wall Street firms opposed Reg Sho with a vengeance. So it was just plain funny that during the depths of the financial crisis Wall Street firms asked the SEC for and received not only a temporary ban on naked shorting of their stocks but also a ban on straight shorts. Add this to the list of things under Wall Street's Hypocrisy Knows No Bounds.
Already yesterday the Wall Street bobblehead crowd was out denouncing the German regulator, because there is no doubt the sky will fall. What's unique about the German move is that they apparently intend to apply it to the government bond market (Reg Sho in the U.S. only applies to equities). The global bond market is many times the size of the global equity market and is significantly less regulated as well; if anything, the naked shorting bond counterfeiting problem is an order of magnitude larger. How large? There is little good information, but studies prior to Reg Sho indicated that it enabled the U.S. financial industry to pocket several billion dollars, and perhaps in the tens of billion, annually, just in naked shorting of stocks.
The focus of financial reform is on leverage, supervision and (perhaps?) dealing with Wall Street conflicts of interest. The naked shorting problem is not on the table, but it ought to be because what we have now is a clearing and settlement system that enables fraud. Reg Sho has not solved the problem:
- it's not clear whether it deals with the "ex-clearing" system, that is settlement outside the DTCC system (Depository Trust and Clearing Corporation, conveniently owned by the Wall Street banks). In trading you may have heard of "dark pools" for trading stocks; well the equivalent in the settlement system is the dark pool known as the ex-clearing system whereby brokerage firms settle (or not) trades directly between themselves, cutting out the DTCC from whence the Reg Sho list is generated and which regulators focus on. We have no idea whether and how much naked short sale fail to deliver activity has moved to the brokers' books outside the DTCC books (although, the usual suspects tell us whatever "minor" naked short problem existed previously is now corrected because of Reg Sho).
- Reg Sho does not apply to bonds and other securities. As I said above, the bond markets are an order of magnitude larger (counting derivatives)than equity markets and significantly less regulated. Naked shorting of bonds should concern governments directly, because it allows the financial industry to sell counterfeit government bonds and pocket money that the government never sees. The direct benefit to the naked short seller is the temporary use of the proceeds at zero interest cost. In the fall of 2008 there were $2 trillion in fail-to-deliver U.S. treasury securities! (it's not clear if this figure includes both the DTCC and ex-clearing systems, but it was a zero-interest multi-trillion dollar loan based just on what is disclosed publicly). There may be a significant secondary and indirect cost to governments (and the rest of us) of naked short sales of bonds - it can drive the price of government securities down and increase interest rates. I have seen no research that studies the potential impact. If it is even just 10 basis points, the cost to the U.S. government would be in the range of $10 billion annually, and many times more economy-wide since government interest rates are benchmarks. Maybe the 10 basis point number is high, but its incumbent on regulators and Wall Street to demonstrate what is the impact.
- It's not clear how effective is a ban on naked shorting in one jurisdiction if the trading can move to a jurisdiction that allows it. ...it's a truly global world.
Ignore the regular bobblehead talk. The Germans might be on to something (Australia, Tokyo and India ban naked shorting of stocks outright), especially if it spurs other jurisdictions to follow, regulators extend the naked short sale ban to bonds and possibly other securities (commodities, where there have been naked shorting allegations recently in gold and silver markets), and to turn the trading, clearing and settlement systems inside out in bonds, equities and other markets, looking under every nook and cranny. Financial regulatory reform is incomplete until this issue is resolved.
[Update] I just saw this at zerohedge and thought to add it as a link: Greek Central Bank Accused Of Encouraging Naked Short Selling Of Its Own Bonds. Things are getting really strange.....I don't understand why the Central Bank would do this, not at all. Was naked shorting of Greek govt debt coincidental or contributory? As more information comes out and the bobbleheaded analysts are pushed aside, it's becoming very clear that naked shorting clearly contributes artificial distorted downward pressure on a market. Have to keep resisting the straw man arguments they keep casting in the way. These straw man arguments are nothing but a distraction and can be easily dismissed because the same Wall Street firms that are sending their analysts out to denounce Germany today are the ones that demanded and got both naked and straight shorting bans on their own stocks in 2008/2009. Through logic I cannot comprehend they now argue that neither banning straight shorting nor banning naked shorting works. Really? Why not? How would it not be price supportive if you banned the seller from being able to sell at zero cost with an unlimited supply? Perhaps when I am less disgusted I will get into the marginal cost of shorting (zero in far too many cases, which by way of rational economic theory would therefore have you keep selling till the security price goes to zero - MC=MR)