Tuesday, May 18, 2010

One more attempt to repeal the law of gravity

In a few hours, Germany will introduce a "temporary ban on naked short-selling and naked credit-default swaps of euro-area government bonds." Presumably, this move is meant to calm markets by protecting them from the predations of greedy speculators. Predictably, however, it only makes matters worse. In the wake of the news announcement, the euro dropped, gold rose, government bond yields fell, implied volatility of equity options rose, and equities fell—all classic signs of a market suddenly more concerned about downside risks to the economy and financial markets. And it stands to reason, because announcing you're going to limit the market's ability to express downside risks tomorrow, only increases the market's desire to protect against downside risks today.

The only good news is that Germany's attempt to repeal the law of gravity (by supposedly limiting negative speculation), can be easily reversed. That's likely not the case with Venezuela's decision today to attempt to put a band around its sinking currency. Venezuela has already made two fatal mistakes, first by printing money (and thus fundamentally debasing its currency), and second by devaluing the currency but establishing a dual exchange rate for imports and exports (thus encouraging all sorts of shenanigans, like the over-invoicing of imports, that effectively funnel capital out of the country). You either respect your currency or you don't; the more you try to prevent it from falling by diktat or by exchange controls, the more you undermine confidence in the currency.

Banning naked short selling may make it harder for speculators to speculate on a Greek default, but it does nothing to change the fundamentals behind Greek debt. It does, however, interfere with markets by making them less efficient, and it heightens investors' concerns: do the regulators know something we don't? Thus Germany is taking steps that could needlessly prolong the crisis. That's unfortunate, but it's not the end of the world. The fundamentals of global growth are firmly in place and likely to carry the day once the dust settles.


John said...

Short selling has a lot to do with hedging other positions as well as making speculative bets on an outcome. At the end of the day it really is not very helpful, IMO.

Governments thinking markets are the problem is wearing on everyone involved with investing. I know it is with me.

Benjamin Cole said...

I agree.
Yet on the other hand, trading volume on May 6, the "flash crash," reached 19 billion (with a "b") shares.
In 1987, on Black Monday (Oct. 19), trading volume was considered crazy heavy at 600 million shares.

19 billion shares traded! (Side note: Jeez, if the exchanges even get a nickel a share, that's nearly $1 billion in fees on one day).

I am worried market gyrations might scare too many investors away.

BTW: Read Page C1 today's WSJ, bottom left, story by Kelly Evans. Seems the Fed is still worried about deflation.

Bob said...

The ıssue ısn't short sellıng,ıt ıs naked short sellıng. I would lıke ıt explaıned to me how ıt ıs ın the best ınterests of the market to be able to short usıng stock that doesn't even exıst. What am I mıssıng here?

Nothıng wrong wıth shortıng, but wıth borrowed stock. John, at the end of the day we are all makıng speculatıve bets on an outcome are we not?

Scott Grannis said...

My view on naked short selling is that it's not all that different from regular short selling. Both contribute to market efficiency.

Those who disagree say that naked short selling allows a greater volume of selling to impact the market, since short sellers do not have to borrow the issue they are selling; selling volume can theoretically greatly exceed the supply of the underlying issue, thus forcing a bankruptcy.

I would counter this by saying that, like all derivative transactions, for every seller there must be a buyer. A naked short seller must find a buyer before he can consummate his transaction. This is similar to the regular short seller, who must also find a buyer. Thus selling sentiment must always be matched by buying sentiment, regardless of whether the volume of trading or the outstanding positions exceed the physical supply of the security or issue in question.

Public Library said...

Market information is completely asymmetric. You are living in a dream world.

Just because banks can find people to dump their speculation onto doesn't make it an efficient market.

Ironically, Goldman was figuring out clever ways to lend Greece billions of dollars when they were already defunct.

I wonder how much they made from shorting it on the way down.

Benjamin Cole said...

OT, but I guess SG is swooning at the hge victory by a Tea Party man.

"Rand Paul, one of the early leaders of the Tea Party movement, won the Republican nomination for Senate from Kentucky Tuesday night, delivering a powerful blow to the party’s establishment and offering the clearest evidence yet of the strength of the anti-government sentiment simmering at the grass-roots level."

Moreover, Rand Paul is an eye-doctor.

So I guess he can see straight. Clearly. Hopefully, not just out of his right eye.

John said...


Yes, at the end of the day a buy or a sell is a speculative wager on the viability of a security at that time and price. It is the difference of opinion that makes markets. As Scott says, whenever a trade occurs, there are two sides. They can both be right or wrong at different times. Many times I am wrong for quite a while before my judgement works out. Sometimes I am just flat wrong...and I eat it raw. I pay for my mistakes.

I am opposed to naked short selling on principle. I do not engage in it and do not condone it. However there are those I have great respect for that believe it can serve to make markets better. I confess I am not familiar with their arguments. However I do believe that banning it, even temporarily sends a message of lack of confidence and even fear that is not helpful to solving the problems at hand. Also, there are many ways to get around such rules and they are widely employed. So I really wonder if it does any good, all things considered. Finally, if there were no good reason to sell something short, no one would, much less be successful doing it.
Maybe the government officials need to examine their own policies rather than blame the markets for their troubles.

Selling short requires collateral to be on deposit before the securities firm will execute the trade. If the trade goes against the seller, more collateral may be required. Of course, gains can be leveraged with more short selling. Each firm's requirements may differ but they are all based on industry wide regulations..or at least they were when I was working...its been awhile. Some short sellers hedge their bets with correlated trades in other areas..or sometimes the short itself is a hedge. The point is, there are disciplines at work within the markets.

There is no escape from market volatility. It comes with the territory. There is also the spectre of panic. It is probably the most powerful human emotion and is why markets usually go down more quickly than they go up. It can work both ways. We saw a brief example last week after the ECB announced their market interventions.

I admit here that I am not the best person to debate this particular issue. I know I don't like it but I have been involved in markets long enough to know that it is certainly possible to lose one's shirt being long OR short...naked or clothed.

Scott Grannis said...

John: Thanks for you valuable additions to this and other threads.

Bob said...


I have to respectfully dısagree wıth you on thıs one as I belıeve your comments to be from an Ivory tower vıewpoınt. In realıty the floodıng of the market wıth non exıstent shares can do nothıng but weaken the market over tıme and make ıt more of a casıno type operatıon. Yes there must be a buyer to every seller and vıce a versa, but who ıs on the other sıde of that transactıon? How ıs theır posıtıon ever balanced ıf the naked short seller, who has at hıs dısposal the ınfınıte pool of nonexıstent shares,just contınues to dump shares? And ısn't ıt the the market maker who ıs forced to attempt an orderly market the one who carrıes the brunt of thıs dısorderly and ınnefıcıent abuse of the market?

John, you saıd ' Also, there are many ways to get around such rules and they are widely employed' What are these many ways? To be clear I am not argueıng agaınst short sellıng, I am arguıng agaınst naked short sellıng as thınk ıf adds nothıng to market effıcıency and ın fact ıs an abusıve tool.

Please excuse by typıng and grammer as I am ın Ankara Turkey and usıng a Cyrlıc keyboard and cannot fınd half of the correct keyes ın theır proper placeç ;))

John said...


Bloomberg is reporting this AM that Germany is not being successful in getting other EU members to go along with their ban, much less NY and London. Germany is not a major financial center so I doubt their efforts will make much difference.

Markets hate uncertainty and Germany's actions here are not fostering confidence. Midnight trading bans make everyone wonder whats going on that we don't know about?

I continue to think you need to allow the markets to trade. They mean well but most of the time government attempts to manipulate the rules usually backfire...as it appears this will.

John said...

Both Hewlett Packard (HPQ) and Deere (DE) have reported outstanding sales and earnings numbers today/yesterday. The global economy is expanding and businesses are benifiting.

The markets are focused on Europe and its political/currency problems. I am still operating on the belief that the panic will abate and corporate earnings and global economic conditions will reemerge as the primary determinate of value.

John said...

Well, Ms. Merkle is in the news again....this time lobbying for a tax on financial markets.

Somebody needs to send these people to school.

Scott Grannis said...

Bob said "In realıty the floodıng of the market wıth non exıstent shares can do nothıng but weaken the market over tıme and make ıt more of a casıno type operatıon."

Those who engage in naked short selling of Greek bonds cannot really flood the market with nonexistent paper. Shorting a Greek bond carries a pretty high cost: the difference between Greek interest rates and, say, German interest rates. Buying a Greek CDS is equivalent to shorting Greek debt. Currently you must pay a little over 6% per year of the notional value you are seeking protection for. Bears are not going to do that willy-nilly, because it puts them on the hook for some serious interest payments. Holding a short position against Greek debt costs you 6% a year, and in order for your bet to pay off, there must be a Greek default. If they don't default, then you are losing 6% per year on the notional amount of your bet. And the more the market pushes down the price of Greek debt, the more expensive it becomes to be a short seller. So the market has some automatic stabilizers built in.