walkitout (walkitout) wrote,

Merkel and the Naked Shorts


According to this article at Reuters, Germany has "banned naked short sales of euro-denominated government bonds, credit default swaps based on those bonds and shares in the country's 10 leading financial institutions".

A short sale is when you sell something you don't own, in hopes that you will be able to buy it back later for less and make money on the difference. A short sale is "naked" when you sold it without so much as bothering to borrow it ahead of time.

Once upon a time, I was employed by a small, profit-free company which went public during the dot com days. They still exist, and are no longer small or profit-free, but at the time, even the most rabid boosters of that company wouldn't have predicted where they would be today. Despite that, even relatively moderate boosters of the company were roundly mocked by people who could not believe the valuations of that company. There was a _lot_ of short selling -- and only a tiny fraction of the company's shares were available for sale anyway, as they were mostly still closely held by the owner, employees, angels, and some institutional investors. Quite a lot of the time, a huge chunk of the shares in existence were tied up due to insider trading rules. Because most financial firms in the US won't let most of their customers engage in naked short selling, there was a high demand to borrow shares to sell them short.

Me, I can spot a corner from a block or two down the street. My boyfriend at the time had the bright idea to find a broker who would let us collect some fees for loaning our shares out to short sellers. It only took a few phone calls (the first few laughed at us), but Painewebber (now UBS) was game. We caught some flack from the CFO (there really is a moral hazard in shorting a company you are a key employee at, but I fought back -- no moral hazard in squeezing those shorts until they bleed). It was a nice additional piece of cash flow.

Every time a short had to cover their position, they were squeezed: they had to pay more than they sold for, because there was so much competition to cover short positions, which raised prices, which required more short positions to be covered, which created more competition, etc. Squeeeeeeezzzzeeee.

Banning naked shorts makes sense. Especially in that case, but I would argue in every case. You can utterly destroy someone who does not deserve it if enough people get it in their head to short it. That's one thing if they can find the shares to sell. But if people are selling more shares than _exist_? That just seems wrong to me. And when they are leveraged (through credit default swaps, which are really more like insurance than anything else), it's like predicting that someone with curable cancer will die, and then aiming a SAM at his house when he starts to get better. It's not just murder: there's a helluva lot of collateral damage, too.

Maybe Germany has figured out that MORE regulation can make your market more popular in the long run. Surely someone will eventually figure that out.
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