Germany’s Ban on Short Sales and Derivatives Contracts: A Cry for Solidarity Among National Financial Market Regulators

On May 18, 2010, the euro, a currency shared by sixteen of the twenty-seven member states of the European Union, hit a four-year low . In response, on May 19th, German regulators announced a ban on credit default swaps and naked short sales. In a previous post, I describe the mechanics of a credit default swap. A traditional short selling strategy involves the sale of a security that is borrowed or owned by an investor who will sell the security at a future date. In a short-sale, the investor assumes that the market has inaccurately valued a security. To profit from the anticipated decline in the security’s price, the investor borrows shares of the security. When the price of the security falls, the investor can purchase a security equal to the one borrowed under the earlier arrangement and profit from the difference between the price set out in the borrowing/lending arrangement and the current market price. In a naked short sale, the investor sells shares that it has not purchased or borrowed. Naked short sales eliminate investors’ economic exposure to the appreciation of the security if their strategy fails and the price of the security increases.

The fear of contagion following Greece’s national sovereign debt woes triggered Germany’s regulatory decree.  According to a recent Financial Times article, the German securities market regulator explained that the the ban was necessary because of the ‘“exceptional volatility’” in eurozone bonds and the considerable widening of spreads on credit default swaps. Large-scale short-selling could have “endangered the stability of the entire financial system.’” Germany drew a line in the sand.

National regulators face fixed jurisdictional limitations. If different jurisdictions adopt inconsistent regulation of these investment strategies, a race to the bottom may follow as markets shift toward a jurisdiction with less restrictive regulation. Presumably, the German government is anticipating solidarity among Eurozone neighbors and friends. The German prohibition is limited in its application to sales that occur in Germany. Most credit default swap contracts, however, are executed and traded in London and shares of German investment banks are held and traded around the world. Any effective regulation governing these investment products will require international coordination.  So far, no other national securities market regulators have joined Germany’s efforts to root out these allegedly nefarious investment activities. With noteworthy inconsistencies in its policies, the Securities Exchange Commission has made clear its intention to enhance limitations on the practice of naked short selling. The EU has also voiced intentions to limit naked short sales.  So, why the hesitation by other regulators?

While there is increasing agreement regarding limitations on naked short selling, there is no common position among regulators regarding appropriate limitations for credit default swaps. (See here and here.) There is disagreement about the economic impact of an absolute ban on credit default swaps and certain short sales trading strategies.  Some economists argue that the absence of credit default swaps, for example, there will be greater difficulty restructuring sovereign debt because there will be less market liquidity. Fewer investors will buy sovereign debt issued by Greece, and as the crisis spreads, Spain, Portugal and Italy because of the inability to buy some protection against the risk of loss on their investments. Credit default swaps offer an insurance like protection that would allow the purchasers of sovereign bonds some down side risk management. Other economists adopt the position underlying Germany’s ban; credit default swaps and short sales offer limited economic or social utility. As regulators navigate the swamp of the continuing financial crisis, assessing the economic and social utility of these investment products seems paramount to stabilizing the global economy. Even if we establish that there are valuable uses for these investment products, such as maintaining market liquidity, we would need to determine that the relative benefits gained from the use of these instruments outweigh the costs. With limited time to sort out the full breadth of the complexities raised by these questions, regulators in many jurisdictions are intensely engaged in this discussion and racing against the clock of investor confidence to reach a viable resolution.

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3 Responses

  1. Frank Pasquale says:

    Very informative post–thanks!

    I think the fundamental problem here is leaving capital allocation to institutions that are essentially a form of legalized gambling. The “quants” at such places have zero sense of social obligation to invest in the types of initiatives (like green energy and infrastructure) that would actually increase long-term economic growth and stability.

    I tend to agree with Uwe Reinhardt’s suspicion of the pro-CDS crowd:

    “Spreads on purely speculative naked swaps can indeed serve as a useful sentinels of brewing asset bubbles or of excess leverages. They can also be used as a genuine hedge on assets for which direct hedges are not available. That will always make it difficult for regulators to distinguish between the truly speculative naked and the quasi-clothed swaps, if it is the purely speculative swaps bets they wish to curb.

    But “mature” and “socially responsible” are not adjectives that spring to mind when one thinks of the financial markets.

    We are dealing, after all, with institutions whose reckless swaps trading contributed significantly to the systemic risk that ultimately dragged taxpayers to the rescue.

    We are dealing with institutions that hid the perilously high leverage on their own balance sheets with cleverly designed repurchasing agreements or off-balance sheet, offshore structured investment vehicles that fooled both the Federal Reserve and the Treasury into a false sense of normality, until the financial houses of cards the financial institutions had built collapsed and, as teenagers in trouble run to Mommy, the bankers ran to government for a bailout.

    Finally, we are dealing with institutions that exported their clever expertise of hiding debt to the very same countries whose debt they now bet with credit-default swaps will default, such as Greece.”

    Given their track record, I doubt the “13 Bankers” described by Kwak and Johnson should have much credibility in policy circles.

  2. …so Germany’s “line in the sand” doesn’t really amount to much. In other words, just political posturing to make it look like government is doing something. How inspiring.

    What some lawyers and government economists consider to be of social utility is not where I’d like to leave the decision process on such matters. As long as there are willing buyers, sellers and market-makers (emphasis on the word “willing”) I tend to see at least some social utility in the transaction. The only problem with naked short selling is if a contract is not honored but that’s the same risk entailed when you buy a future delivery of a car, an August grain future or next fall’s semester at law school. As to roiling the markets; if the underlying product is a good one, the short-seller can be burnt; if not, then the short-seller is performing a service by alerting the rest of us to a potential problem.

    …and for a trip down memeory lane, let’s remember the naked short sale ban on Freddie and Fannie stocks from two years ago. ‘Cause those types of sales were clearly causing all the problems for those 2 companies.

  3. Nate Oman says:

    Correct me if I am wrong, but don’t naked shorts also eliminate the problem of short squeeze risk when lots and lots and lots of people use a short to hedge risk than goes bad? For my money, the German regulatory response looks like an attempt to demonize financial markets as the cause of the Euro’s current distress. The problem is that financial markets are NOT the cause of the Euro’s current distress; that honor goes to generous but fiscally irresponsible welfare states.