Around The World...Banning Short Sales

It is amazing how much controversy there is surrounding the ban on short sales. While the decision has drawn relief from some quarters, let there by no doubt that there are quite a few people who are unhappy with SEC's decision. While UK took the first step to ban short sales and added pressure on other markets to respond, the US followed suit shortly. And now it looks like the entire world is jumping on the bandwagon with Australia, Taiwan, Netherlands and Germany also confirming the ban of short sales in their respective exchanges.

I suspect that the ban was done to appease the common investor who has probably been wiped out in the ongoing financial tsunami and as the politicians realized they have to do something to make themselves look good. The Fed and SEC have clearly indicated with this decision, that they are and will go to any lengths to preserve the US financial system collapse including changing the rules midway through the game, with no public comment or participation if required. Note that the ban on short sales does not mean that stocks will only go up. China's market has fallen by more than 50% this year alone even though short selling is not allowed at all.

By banning short selling world over, it looks like what the governments are clearly worried about is the fine line between "freedom" and "manipulation". I personally think that there is nothing wrong with borrowing stock to short, but given the sensitiveness in the global market, the worry is that even a small/negative sentiment can cause a big shift in markets which in turn can cause greater panic worldwide. Note that there can be 2 kinds of short selling. Normal short selling occurs when investors borrow shares and sell them, hoping the stock will fall and they can buy back the shares at a lower price. Naked short selling occurs when an investor sells a stock without first borrowing the shares, and that practice allows investors to flood the market with sell orders, potentially driving down share prices.

Why the ban maybe difficult to enforce

• First off, this is only a temporary ban. Let’s wait and watch if the ban is made permanent. If it is, it will significantly change the rules of the game
• Over the past few years the options market has grown to reach the ordinary investor. There is nothing that short selling provides which cannot be done through put options, albeit at slightly higher cost, due to the options premiums and the bid/ask price spread.
• Volumes in credit-default swaps and other derivatives trades and options are likely to rise in the wake of the short-sale restrictions - This is likely to cause a bigger headache as these complex derivatives are not subject to full disclosure and they are not publicly traded
• This will cause the traders to start focusing on non-financial stocks which can still be shorted via ETF's etc.
• Hedge Funds will be unable to hedge large positions and will likely take some hits. (Not sure what the impact will be to the broader markets once hedge funds start to fail)

Disclose Positions?
Apparently just banning short sales was not enough. After the announcement, pressure mounted for the SEC to do even more as its counterpart in London increased its regulatory responses. By evening the SEC came up with a new surprise – It required investment managers to publicly report their short positions weekly. Though I believe the SEC has every right to obtain and review information about short positions for market surveillance purposes, but forcing public disclosure will have serious consequences for the market. Companies will most definitely retaliate against short sellers. Portfolio and fund managers will lose their ability to manage assets without revealing their strategy. Once someone is short selling a security, other traders will simply do the same thing adding more pressure and this may trigger panicky selling if an investor sees that noted short sellers have shorted the stock.

These are extraordinary times and agreed that we need to support the govt’s efforts to ensure that fraud and manipulation have no place in this market. But the confusion and scapegoating that has ensued may well do more harm than good. Short selling or even naked short selling cannot destroy a company that has any real underlying value to it. Bear, Lehman and the other financials didn’t getting pounded because of short selling. They got pounded because the leverage game was over. I think because of the temporary ban, there is going to be a big rally - albeit an artificial one - which will end by still not revealing the true intrinsic value of the stocks.