Markets

Hang the Short Sellers?


Visitors pass beneath giant screens displaying share price information inside the Madrid Stock Exchange.

Photograph by Angel Navarrete/Bloomberg

Visitors pass beneath giant screens displaying share price information inside the Madrid Stock Exchange.

People should not be able to profit from falling share prices.

The premise sounds reasonable enough. After all, pensions, 401(k)s, consumer confidence, tax receipts, and this reporter’s livelihood all to some degree depend on a healthy stock market. What kind of brute would cash a check drawn on the financial misery of the masses?

Disdain for short selling—borrowing shares with the intention to buy them back later at a lower price—seems even more unassailable when the shorts’ targets are systemically vital, taxpayer-backstopped financial institutions. This is why Washington shielded banks and brokerage firms from short selling in the immediate wake of the Great Bailout of ’08. And it’s why European governments under financial siege are attempting to do much the the same now (again, actually), even as there is scant evidence that these kinds of bans are effective.

Amid a worsening debt crisis and with bank shares at record lows—as the euro tumbles—Spain and Italy (members of the prestigious bloc of PIIGS) reinstated a short-sale ban on stocks today. Madrid’s market regulator banned negative bets on equities through shares, derivatives, and over- the-counter instruments for three months. Italy, citing “grave tensions” in financial markets, prohibited the practice on 29 banking and insurance stocks for one week. The nations announced a similar ban in August 2011, alongside France and Belgium, as European bank stocks tanked; most bank stocks extended their declines once the bans were lifted. (So far, France and Belgium have not indicated the desire to enact another ban).

You can appreciate the good intentions. European governments are trying to defend their banks, whose plummeting market valuations run counter to their adequate capitalization, which is both a national and global priority. Spain’s IBEX 35 index has plunged 39 percent in a year and has fallen nearly 10,000 points from its high of just under 16,000 in 2007. The market is betting that the country’s recent €100 billion ($121.3 billion) rescue plan isn’t enough to have Spain stand on its own feet without additional help: Madrid’s increasingly prohibitive 10-year bond yields just shattered another euro-area record. Its banks—and the broader euro-area economy—are living on the edge.

Can you blame a government for defending its national(ized) assets?

“I don’t think it is particularly smart, but it is to be expected,” says Owen Callan, senior dealer at Danske Bank (DANSKE:DC) in Dublin. “Last time around, it didn’t really have any lasting impact. This is trying to avert hedge fund speculation, but the sell-off is not about speculation. This is not hedge funds trying to bring down the market.”

Callan says selective euro-area bans can have the unintended consequence of pushing short selling to open, liquid, and otherwise healthy markets such as Germany’s DAX, where institutions looking to hedge risk will take their short trades. “The short risk is mis-allocated into other markets,” he says, “so it can drag even the good markets down.”

Of course, opponents of short selling rarely admit that there is already a natural check on the practice, one that has far more clout with traders than any regulator: By definition, a short seller stands to lose an unlimited amount of money if he bets wrong. (A stock or currency can keep going up; at most it can fall to zero.)

Contrary to popular belief, this does not always boil down to our pain equaling their gain. Witness the recent travails of hedgie John Paulson, the man who made billions and a name for himself betting on the housing collapse.

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Farzad is a Bloomberg Businessweek contributor. Follow him on Twitter @robenfarzad.

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