France, Spain, Belgium and Italy have all announced short-selling restrictions on certain financial stocks and the derivatives linked to them. France banned short selling on 11 financial stocks for 15 days, the Spanish ban covered 16 stocks for 15 days, Italy’s ban covered the stock of 29 companies for 15 days and Belgium banned short selling on four stocks for an indefinite period.
These bans followed large drops in banking stocks the week of the 8th of August 2011, and it has sparked a debate between European regulators with The Netherlands, Britain and Austria refusing to follow suit. Meanwhile, Germany is calling for a Europe-wide ban on naked short selling.
What is shorting?
Shorting involves opening a position on a financial product by selling the product and then buying it back at a lower price, profiting on the difference between the opening and closing prices.
While going long (buying in the hope that a price will rise) allows traders to profit in rising markets, short selling enables a trader to make potential profits in falling markets as well. Often difficult to do when trading traditional shares, this is one of the often-touted advantages of derivative instruments like CFDs, which often make it just as easy to go short as to go long.
Why the bans?
European banking stocks have recently been moving on rumours about the health and funding needsof eurozone debt. The DJ Stoxx index of European banking stocks fell 17% in the first two weeks of August, and fell 37% from its February peak.
Having hit a 28-month low on Thursday August 11, the European Securities and Markets Authority (EMSA) has said that short selling combined with rumour mongering can lead to market manipulation.
Has this happened before?
Similar steps were taken at the height of the global financial crisis following the collapse of Lehman Brothers in 2008, when the US Securities and Exchange Commission (SEC) and the UK Financial Services Authority temporarily banned shorting in a number of banks and financial institutions.
Although this resulted in share borrowing falling during the three-week US ban, financial shares continued to crash, raising questions about whether regulators should interfere in the free market.
Even before the financial crisis banking stocks resulted in regulator concern. In 1934 the US Securities and Exchange Commission introduced the uptick rule, which was then implemented in 1938. The uptick rule stated that before an investor could go short on a stock it must trade higher at least once. The uptick rule was intended to prevent investors contributing to falling stock prices after the Great Depression.
Are bans on going short successful?
London analysts, traders and academics have questioned the value of short selling bans, contending that they damage the market by disrupting market functioning and reducing liquidity by closing out some market participants. Such restrictions also don’t address the causes of investor concerns; in this case, the eurozone debt crisis.
In the global financial crisis, former SEC chairman, Christopher Cox, said the greatest mistake of his tenure was implementing the three-week shorting ban in 2008. A Credit Suisse study found that the prices of the shares of the 799 institutions restricted from shorting only fell by 1% less than the broader market.
Returning to the 1938 uptick rule, in 1963 the SEC established three objectives to assess whether it continued to be effective:
- The rule should allow relatively unrestricted shorting in an advancing market
- The rule should prevent traders from going short at successively lower prices, eliminating short selling as a way to pushtool for pushing the market down
- It should prevent short sellers from accelerating a declining market
Using these objectives, the SEC established a pilot program in 2004 to determine whether the uptick rule was still effective. It found that, although the elimination of the uptick rule increased the volume of stocks that were short sold, it did not increase the percentage of stocks that were shorted.
Following these results, the rule was eliminated on July 6, 2007, though there were calls to reinstate it later that year and throughout the 2008-2009 financial crisis. Those supporting the uptick rule have argued that the conditions of the 2004-2006 pilot program were different to those of the 2008-2009 market crash, and have said that reinstating the rule will protect the share prices of struggling businesses, which have been driven down past their fundamental value by widespread short selling.
In defence of short selling
As seen from the use of the uptick rule and the US ban on short selling in 2008, restricting shorting does not make a significant impact in supporting falling markets.
Although going short has gotten some bad press, it is not bad, shady or unlawful. It is a trading technique that gives a trader the opportunity to profit in falling markets as well as rising ones, and is also valuable for correcting asset prices that have been pushed to highs that aren’t supported by fundamentals.
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