In a move to stabilise the markets Germany last night announced a ban on short selling of some riskier financial instruments.

This though seems to have had exactly the opposite effect and both the Euro and sterling fell sharply on the news with the FTSE tumbling in sympathy.

Late last night the German financial regulator, the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) or BaFin for short, decided to ban short selling in Eurozone government debt, naked short selling in Eurozone sovereign CDS and shares of certain financial institutions, which has created this market uncertainty in both UK and European markets.

Basically there are two sorts of short-selling or ‘shorting’ the first is legitimate, the second is termed ‘naked’ and in most cases outside market.

Normally people buy shares on a simple long basis’. That is they buy them now in the expectation of not only a dividend income but also that their price may rise resulting in capital gain.

When shorting, the speculator borrows shares and sells them at today’s high price. Once they have fallen sufficiently the speculator then buys them at a lower price and gives them back to the person they borrowed them from and pockets the difference. In the interim they may pay a form of rent for borrowing the shares, with any dividends going to the actual owner of the shares.

In order for such a transaction to be legitimate, not only should it not be done with stock specifically prohibited for shorting but also:

  1. The speculator must have borrowed the security or made such an arrangement in good faith.
  2. The speculator has a reasonable belief in their ability to locate and borrow the security before settlement day.
  3. It has documentary proof of either of the above or it is considered as naked short selling.

When naked short-selling, speculators could end up dealing in far more stock than is actually available. This can distort not only the value of the stock itself but also the markets. This is also highly risky to speculators (as illustrated by the Volkswagon case when speculators shorted the company on a naked basis not realising that Porsche owned 74.1% of the shares. The speculators were forced to spend hugely chasing  a small amount of stock so as to cover their positions, losing massively on the way).

Many see shorting as a sort of unethical practice by betting against companies or countries, but an equal number see it as a market balancer allowing negative sentiment to be expressed against the normal ‘long’ optimism. The general rules as outlined above may also lead to inadvertent short selling as some transactions are conducted on a ‘good faith’ footing.

Germany’s unilateral stance, which they tried to extend across the EU and UK has not been taken up by other countries as yet. This makes the German ban a bit academic (and possibly purely for internal domestic political consumption) really as speculators will chase the trade round the other available markets. It has also had the opposite effect to that intended.

Comment Here!