The German Short Sale Ban: Parachute or Anvil?

Europe is thrashing about like a gaffed fish on a boat deck.  The proof?  In a sure sign of desperation, and an effective confession of impotence, Germany has instituted a broad ban on short selling:

Germany will temporarily ban naked short selling and naked credit-default swaps of euro-area government bonds at midnight after politicians blamed the practice for exacerbating the European debt crisis.

The ban will also apply to naked short selling in shares of 10 banks and insurers that will last until March 31, 2011, German financial regulator BaFin said today in an e-mailed statement. The step was needed because of “exceptional volatility” in euro-area bonds, the regulator said.

The panic is particularly evident in the hurried nature of the ban–it goes into effect almost immediately.  (In fact, it went into effect a few minutes before I posted this.)

And it don’t stop there, folks.  Germany’s ruling coalition is also calling for implementation of a transaction tax.

Germany.  Shooting the messenger with an MG-42.  Fat lot of good it will do them.

Indeed, if anything, these measures will make things worse.  This is true in part for signaling reasons.  Markets can smell desperation, and react to it.  This is a desperate move that signals utter policy bankruptcy, and an unwillingness to grapple with the underlying problems.  If people want to short, it is because they think things are overvalued.  And nothing shouts overvalued like financially strapped governments with deep structural budgetary problems spending time and effort tilting at speculative windmills, rather than tackling these underlying problems.  And if the Germans thought things were under control, why take such measures?  The immediate inference is that the Germans think things must be pretty bad.

These measures will also make things worse because they will impair liquidity, and shift selling pressure into other markets.  Some “naked short” CDS are in fact hedges.  Dirty hedges, but hedges nonetheless: market participants may short a more liquid credit in order to hedge a position in a related, but illiquid credit (perhaps one for which no CDS is traded at all).  But if they’re doing this, it’s because they want to reduce their exposure.  The ban doesn’t make that desire go away.  So, they’re likely to respond by selling off some of the more illiquid cash positions.  Shorting liquid bank stocks can also be a dirty hedge for exposures in less-liquid bank stocks or debt.  Again, the ban will redirect some selling into less liquid instruments.

The transactions tax, if implemented, could be especially pernicious in these conditions.  It will reduce liquidity.  It will also impede the reallocation of risks to those willing to pay the most for them.  This is hardly the way to bolster the financial sector.

All of the measures Europe has adopted, starting with the bailout, to the not-so-sterilized intervention that has cratered the ECB’s credibility, to the short sale ban, fail to come to grips with the underlying solvency problem.  Indeed, they all signal a basic refusal to deal with that–especially the last.

In the initial EUphoria following the announcement of the $1 trillion initiative, I thought that the key indicator of its ultimate success would be the Euro.  And after an initial spike, it has been down.  Down hard.

It is now trading at a 1.21 handle.  It is down 2 cents since about 11:30 CT today (CME futures).  I haven’t been able to confirm the time that the BaFin announcement was released, but I received an email with a story confirming the ban at 1:30 today.  So I suspect that most of the hard selloff in the Euro was a direct response to the announcement.  (Hey, if you can’t short the governments or the banks, might as well short the currency!)

That’s great for those of us planning a European vacation (volcanoes permitting), but it is a very bad omen for Europe.

It ain’t so great for the rest of the world either.  The European chaos, combined with China’s attempts to de-fizz is weighing on commodity prices: oil is down (below $70/bbl on the WTI) and copper is down too, below $3.00/lb.  This does not bode well for growth in the near term.

Look out below.  Especially in the Eurozone.  And no, a short selling ban doesn’t make much of a parachute.  An anvil is more like it.

About Craig Pirrong 223 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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