Wednesday, May 19, 2010

On Naked Short Selling

News that Germany has imposed an absurd ban on naked short-selling has caused a flood of emails asking about naked short-selling. The questions go along the lines of this emailer:
I thought not allowing naked short selling was a good thing from the Austrian perspective?  Are they banning short selling or just naked short selling?  I thought I read on an Austrian site where naked short selling is similar to fractional reserve banking in that one could manufacture a number of shares beyond those even issued by the company  - selling them short?
I am I missing something here?
Actually, naked short-selling is a much more complex issue than the way it is generally presented in the media.

Most of those screaming against naked short selling is just simply wrong. Some CEOs claim their stock is down because of naked short sellers, when it is far from the case. The action ban by Germany implies that the current PIIGS crisis is being caused by naked short-sellers, this is simply absurd.

There are clearly naked short-selling abuses, but they are few and far between, and have nothing to do with the current crisis in Europe.

To understand how naked short selling  provides a legitimate role in the markets, one has to understand the role of a market maker. A market maker's role is to provide a "market" for a stock when a buyeror seller comes by. . A market maker sees orders coming at him all day long, both buys and sells. Now suppose at one point during the day he is flat the stock, he is neither long nor short. Remember, in his trading day he will see both buys and sells. Suppose the next order that comes along is an order to buy 10,000 shares, since in our example he is net flat, one way he can fill this order is to sell "naked" the 10,000 shares to you. He does this because he knows that in the day he will also see sell orders from which he will be able to buy stock to cover his naked short.

This is a perfectly legitimate market making function. To ban such activities would make markets much less liquid and much more volatile. Consider the above example if the naked short selling were banned. If that 10,000 share order couldn't be filled by the market maker as a "naked" trade, it would force him to go out into the market to "find" the 10,000 shares. The only way he is going to do this is buy raising the price. Thus, it takes the market maker out as a willing supplier and pushes the stock price up for the buyer, i.e., the market becomes less liquid and much more volatile. How volatile? Well let's continue with our example. In the case above of the market maker where he sells 10,000 shares naked and then buys in 10,000 shares when a seller comes along, but this changes with the ban. With the ban on naked short selling, the market maker is taken out of the first side of the trade and now when the 10,000 share seller comes in, the market maker has no "hard" demand for 10,000 shares since he is not naked short. Thus, if he buys the 10,000 shares from the seller he is apt to do it at a lower price since he will have to hold the stock in his inventory as opposed to simply covering a short. Thus, he has portfolio risk introduced in the picture and will likely do thetrade at a lower price, then if he had a naked short he needed to cover.

With the banning of short sales, we can see that buyers will pay higher prices and sellers will pay lower prices. It makes the market less efficient.

There are naked short selling abuses, but they are few and far between. To ban naked short selling because of such abuses is absurd. The abuses themselves should be dealt with on a case by case basis.

As far as Germany putting a ban on all naked short-selling, it will suffocate many legitimate market makers and make the markets less liquid and efficient, and make them much more volatile. It will do nothing to make it easier for Greece or the other PIIGS to pay their bills. Naked short selling has nothing to do with the PIIGS crisis. The PIIGS are in crisis because of their own doing.

The ban on naked short selling by Germany is a drone strike that has hit the wrong car.

7 comments:

  1. RW - I agree that Germany's ban of naked short selling is a red herring and does not address the financial problems they face. Essentially their problem is one of moral hazard as the German govt. (via German taxpayers) bails out German banks that are exposed to bond defaults by the PIIGS, by funding the budget deficits of the PIIGS. The solution is to allow the PIIGS to default, the banks to fail and the creative destruction of the market will restructure their economy more quickly and fairly than the bailout policy.

    However, you didn't really answer the question about naked shorts being similar to fractional reserve banking: "that one could manufacture a number of shares beyond those even issued by the company - selling them short?"

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  2. @Efinancial

    The answer to any naked short selling "problem" and I emphasize it is probably one ten thousandth of the size of the problem that some would have you think it is, is the same solution you would have in a free market for fractional reserve banking withdraw the funds (or in the case of naked shorting the stock certificates) and those that can't produce go bankrupt (and maybe to jail).

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  3. Ban naked short selling. If the request to buy 10,000 stocks at a given price level can't be fulfilled it is the law of supply and demand. Why would anyone without vested interest want to circumvent this perfect market? Raise your offer to encounter a seller or back away to play another day. The average people cannot sell what they do not own. Why should you? Paper gold certificate are short selling 100 to 1 they could never find enough gold to cover 1% of the greedy insanes that buy them. Gold bullion is 400 ounces at 1/2 million a bar, not manny can buy those. Still it is no excuse to be silly and go short naked.

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  4. You said:


    "There are clearly naked short-selling abuses, but they are few and far between, and have nothing to do with the current crisis in Europe."

    What a load of crap. There was a story in Bloomberg years ago estimating naked shorting abuses in the hundreds of $billions.

    One point that your probably right is that ending NS alone won't save the situation: it's only a start in the right direction... now we need criminal investigations into all those companies engaged in the abuses, as well as into the regulators hired at 6 figure salaries to surf for porn while they did it, and to bring back G/S and regulation with teeth.

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  5. RW - thanks for the response, I couldn't agree more.

    Anon (2:56PM) there is no "perfect market" Suggesting the buyer "back away to play another day" delays the transaction increasing its cost and reducing its efficiency and causing a general reduction in liquidity as RW has pointed out. These are not good things.

    Anon (4:18PM) the only time I want to see teeth is when someone is flashing me a friendly smile. Otherwise they are totally inappropriate.

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  6. "Suggesting the buyer "back away to play another day" delays the transaction increasing its cost and reducing its efficiency and causing a general reduction in liquidity as RW has pointed out. These are not good things."

    Yeah, really? Explain to me how "financial market efficiency" and the general welfare correlate again? It seems to only correlate with the welfare of the financial marketeers.

    Economics: the science of obfuscating how Wall Street eats a free lunch.

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  7. Anonymous posting: The ability to be a bombastic ass and have no balls at the same time.

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