Earlier this month, after several consecutive days of sheer panic, 4 European Governments ended up deciding to outlaw short selling on their financial securities. This was following impressive declines as rumors of high exposure to lower quality Italian and Spanish debt. Regulators and bank managers were putting out messages about these rumors and trying to calm the markets but those had been unsuccessful. What happened on that Thursday when rumors started emerging of a ban of short selling? The markets rallied big time finishing the day significantly higher with the run keeping up the next day.
It would certainly seem to have been a great decision to stop these vicious short sellers. But was it really?
Why Banning Short Selling Was A Good Thing?
-Temporary Rise: There is no doubt that this puts upward pressure on stock prices. Why? Because not only do short sellers need to cover their position (buy) but it also gives confidence to current and future investors that the downward pressure will be much lower.
-Less Rumors: While it is illegal to do, everyone knows that short sellers are very keen on having rumors (true or false) about their short positions. In the case of banks, the risk to the economy certainly exists as any run on a bank would create panic in the entire country and perhaps worldwide. Having a healthy bank go down because of such rumors would be tragic and dangerous.
Good In The Short Term But Bad Over Time?
-Past Success: It is far from the first time that such temporary measures have been adopted and you will have a lot of trouble finding anyone who’s found that it has worked. Why?
-Short Sellers Can Still Act: Through ETF’s or derivatives such as options, it is rather easy for those selling to keep the same exposure as they had even when a ban occurs.
-Market Confidence: In many ways, moves like this are signs of panic by governments and regulators which is not good in the medium to long term because it scares off investors that prefer investing in “safer” markets.
-Confidence In The Banks: Banks such as Societe Generale depend on confidence for much more than their stock price. Can you imagine all of their short term trades and off market funding requirements that are done every day. Any lack of confidence will cause some of their counterparts to either avoid trading with them or increase collateral calls. The main problem remains the issues (sovereign debt risk), not the short selling.
-Reduces Market Efficiency: Short sellers can have a very positive impact in the markets in improving pricing efficiency. Through my own long and short trading for example, I try to determine under priced and overpriced securities. That is generally the case for short sellers as they usually have some other position going against the short.
End Of The Line Impact
I personally think that it will take some time to judge the results of this latest ban on short selling and by time I mean months or years. I personally disagree with the idea but perhaps if it is done for a very short amount of time in order to avoid panic, it could work well. What are your thoughts on short selling?