Tuesday, May 18, 2010

Germany bans naked short-selling, but it's better to solve the problem than look for scapegoats

Germany today banned the naked short-selling on shares of its top 10 financial institutions. This ban also applies to credit default swaps (CDS) on Euro government bonds and Euro government bonds themselves.

Banning short-selling is a common tool that is used when there is turmoil in the markets. For example, during the financial crisis in late 2008, the US government banned short-selling in an attempt to prevent market declines. However, it was ineffective in preventing 300 and 400-point declines, since those still occurred after the ban was put in place. In fact, research has not shown that bans against short-selling actually decreases decline in markets. For example, the graph below shows that the Euro has been falling relative to the US dollar since November. This is due to debt issues in Greece and the PIIGS, and should not be blamed on short-sellers.

What European governments should realize is that rather than looking for scapegoats when stocks are falling, they should solve the underlying problem that is causing the decline. If the fundamentals of the Euro are strong, then few people would short the Euro and risk losing money. In this case, if the health of the German banks were strong, no one would short the shares of these banks and risk losing money.

I expect this ban to have no effect in slowing the decline in shares of German banks, the rise of the prices of CDS and the rise in yields of Euro government bonds. However, with this decision by the German government, it is very likely that other European governments such as France and PIIGS countries would follow with similar measures.

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