The Italian regulator is requesting owners of bank shares not to lend them to short sellers – there is no mention of Government debt. Banning short selling of secutrities seems odd to me. If the banks are over priced then short selling is a good thing – it corrects the price to accurate levels. if the speculators are wrong then they will lose money and rightly so.

Your scenario regarding CDS’ and Government debt is an interesting one. Wouldn’t this come under market manipulation and be banned?

Here is a recent case where a trader manipulated the market to gain on spreadbets and CFDs and he was prosecuted for market manipulation. A much smaller scale of what you are suggesting, but is the same thing.

http://www.investoo.co.uk/spread-better-ordered-to-pay-1m-for-market-abuse/

Shorting Govt debt would presumably increase borrowing costs for a country when they need to roll over their debt. But shorting will only work if the market percieves underlying weakness in the ability for the Government to repay, otherwise there will be plenty of people happy to buy up the sells, resulting in big losses for the speculator.

Dave,

Have you got any evidence of CDS’s on Italian debt being purchased by people without exposure to Italian debt then? That would be the key thing here – actual evidence of wrong doing.

Watchman,

But even if they did not have exposure to Italian Debt it isn’t illegal to take out a CDS.

What might be illegal if they deliberatly manipulated the market so that Italy actually defaults and then they obviously make a big gain on the CDS. However I would be amazed it if was possible to manipulate the market sufficiently to make Italy default.

Fungus,

Sorry – I was checking to see if Dave had any evidence of behaviour he sees as wrong (and which I see as dubious – betting on investments seperately to the original bet does seem house of cards like).

It might not be illegal – Dave acknowledges that in his post by calling for it to be made so – but that does not make it a good idea. Someone might be able to explain the benefits of CDS’ to me (perhaps minimising risk – but spreading individual risk might not be a good thing in a market because it in effect reduces the point of having a market).

I have some reservations about the usefulness of naked shorts. However, if you had left at that you would be making a good point shared by others. Quite ironic, that you imply hedgies always win in the same week that many hedge funds who arbed the BSyB shares will be sitting on huge losses.

Short selling borrowed securities in the hope of buying them back at a lower price is a perfectly legitimate practice. It is what makes a market and the self-fulfilling prophecy is nonsense otherwise everyone would be doing it. When a share is falling it is the short sellers who are in the market arresting the fall as they need to buy back the share to make money. Without short sellers the market would be hugely more volatile as there would be no bid and shares would fall through the floor.

Your horse racing lay and back analogy is interesting. The logic of your position is that there should only be backers and no layers. A strange market would ensue where the backers would find there was none to take their back bets. Moreover, you are implying that the act of short selling makes the underlying happen and the very act of laying your horse makes it lose. A truly magical world. If you want Manchester Unite to lose the title next season just lay them and as if by magic they will lose.

Buyers of CDS on Italian debt did not make them a low growth economy with a huge debt burden. Moreover, they did not turn them into a political basket case. That was Italian governments who did those things. The sellers of Italian bonds and the buyers of CDS are the canary in the coal mine pointing out that the Emperor has no clothes. We get this every time investors dump the debt of a eurozone member. Xenophobic rants about Anglo-Saxon media and speculators are always to blame according to domestic grandstanding politicians. It is never the case that the so-called speculators may be right and the country is in a fiscal mess. Yet, strangely enough the speculators have always been right over the last two years in the eurozone and the grandstanding politicians wrong.

The Europeans have been warned for at least two years if they do not solve the root of the problems, the market will pick off the weak one at a time. Their solutions have treated the problems as liquidity when the problem is solvency. Moreover, their fudged solutions have only made matters worse because they are a bunch of denialist incompetents. The monetary union as incorporated does not work and the so-called speculators are merely pointing that out.

@ 1. Fungus

That trader did absolutely nothing wrong or illegal. He merely spotted a flaw in the system and the £1 million fine was a gross abuse of power. However, government agencies have more money than him and can use that state money to make an example of someone for doing absolutely nothing wrong.

Well said, Richard W.

Seconded… Well said Richard W…!

There’s some good economic comment on this blog, this unfortunately this piece seems just to be a rant at the evil bankers, without any understanding of the actual fundamentals at play.

“I have some reservations about the usefulness of naked shorts.”

Well that’s very big of you, Richard W. But let’s not be so mealy mouthed. What would you do about it?

If there’s anything that makes me puke up, it’s city speculators making out that their greed and grotesque practices are some kind of social service to the rest of us.

When the capital development of a country is a by-product of the activities of a casino, then we are likely to be ill-served. When the planet is at the mercy of a set of greed-crazed, testosterone-addled, cocaine-fuelled psychopaths, that can be guaranteed.

No market understanding – Stop writing and added to the fires of the uninformed. When are people seriously going to get a grip and place responsibility where responsibility is due? If those in governments cant seem to do it I don’t think we will ever get to a point in which the public understand anything about the world..great!

Easy money? Of course. And the City Boys get to do something very like this, through a combination of using Credit Default Swaps and a tactic called short selling.

Easy money? Both of these are zero-sum transactions. Someone has to win. Someone has to lose. You can only short sell if someone else thinks the price is going to go up. You can only buy a CDS if someone very smart with a lot of high powered computers thinks the risk is small. It is not easy money at all. These people tend to know what they are doing. Either way, the economy is going to do what it is going to do anything. Short selling just gets more information to the marketplace earlier and so helps smooth out the inevitable plunge in price.

It is also common to borrow shares and bonds that you do not own, sell them in the expectation that they will fall in value, and then buy them back at the lower price. The process often results in a self-fulfilling prophecy.

Name a single case where it has been a self-fulfilling prophecy. This is where naked selling improves the market – the more people buy and sell, the harder it is to have such a big influence you can shift the market single handedly.

The bonus is that if the firm – or in the case of government debt, an entire country – goes pear-shaped, you get to collect on the CDS. As such cover is obtainable at just a few percentage points, the payouts on offer far exceed anything the ordinary punter ever gets to collect on.

Yeah but the cover costs a few percentage points because the issuer knows that the chances they have of paying out are tiny. The higher the risk, the more such instruments cost. Naturally.

Dave, this article doesn’t really have anything interesting to say. There are clearly loads of issues that need to be reformed in finance, but there are plenty of better ways to argue them. Unfortunately, when stuff like this gets written, it brings all sorts of apparent experts on finance who use arcane jargon to shoot you down.

For the record guys, I like short-selling, but the idea that short-selling is necessary in order for prices to be corrected is dubious. Most markets in the world correct their prices by people simply selling, not short-selling (which is a closed-circuit process requiring people to buy again). In fact most markets in the world do not require a short-selling mechanism at all in order to correct prices… um, like for example, the property market. Yay, come on out all you EMH pundits

“In fact most markets in the world do not require a short-selling mechanism at all in order to correct prices… um, like for example, the property market. Yay, come on out all you EMH pundits”

Most markets in the world do not suffer the psychology of panic selling, the equity markets have a different psychology and time frame response than the physical housing market – supply can explode in a single afternoon. Have we ever seen the housing market lose 50% of its value in a 24 hour period? No.. I do not think we have yet I have witnessed it time and time again in the equity markets, a market that’s incredibly responsive to the present moment.

Short sellers do not short a stock without reason, if a stock is in decline shorts appear, there buy to cover stabilizes price…perhaps we should ban people from shorting because of the fundamentals as well,over valued asset with no breaks and only a panic reaction to reality when it finally emerges from behind the shadows is the way forward to a stable market.

By the way I like your example of the property market as a market that does not require a short-selling mechanism (which is a closed-circuit process requiring people to buy again) to correct prices…we moved just last month and decided against buying a house to move into as people normally do when they sell..we now live in a tree:D.

I used to live in a tree too, now I just rent.

I once wrote a report on the impossibility of trying to short property. It’s one of the most riveting reads in the worlds: http://sites.google.com/site/pdigdraft/archive/What%27sgoingoninpropertyderivatives-March2010version.pdf?attredirects=0&d=1

Suitpossum thank you for that I was aware at the time of posting, the point I am making is different markets work in different ways its useless to compare two and say because one does not have a shorting mechanism the other does not need it and the housing market is the worst market to compare for many reasons.

OK, all this article proves is that Dave Osler knows not a baby’s shit about financial markets.

Let’s start with short-selling;

It is perfectly legal, but you have to borrow the stock to deliver the bonds/equities you have sold short. This is VERY expensive on the whole. So it is very hard to remain short for long periods. Given you also have to deliver it is very easy to get squeezed out of positions – by longs.

That of course is before you consider that a MASSIVE short interest in a company teds to top out at around 5%. Simply, it is utter nonsense that short sellers can somehow make prices going down a self fulfiling prophecy.

Using the example of banning short selling, as they have done in Europe in a few occasions for different products, we can look at what the result has been. Every time, the market views it as weakness, and that something is dreadfully wrong with the country/company, and people try and sell the stock they hold. Those people, the great majority of market holders (remember, HFs are still a tiny minority of invested cash), will be pension fund style, real money, long only investors. Not only has the market been screwed by a well meaning but totally moronic regulator, but now the only natural buyers in a falling market, the short sellers, aren’t going to be there.

The result: an even worse selloff than you would have otherwise had without the short seller. A lot of the short bans post Lehmans saw this kind of action.

And before you start – the Italian regulators banning shorting of the Italian banks did nothing to stop their prices falling. The ECB stepping in to the market and buying Italian gvernment bonds did.

Now lets have a quick look at CDS:

Firstly, it costs a lot of money to hold CDS. It’s not a cheap bet against a country to buy it.

((Greek CDS at 2380bp for 5y translates to paying 5m upfront + 100k a year to protect against default for only 10m of Greek debt)).

Secondly, whilst HFs etc do use it to speculate on country spreads widening (and the reverse too), the main users are pension fund/real money investors.

CDS spreads are highly correlated to the spread between a bond and some underlying. Lets use the example of Italy 5y bonds. The spread of the bons over German bonds is 322bp (= 3.22%). The CDS is at 289bp.

As a pension fun, I can buy the Italian bond, buy the CDS and get a yield pickup of 33bp. Whilst I don’t get the entire benefit of holdin gthe italian bond, I don’t have all the risk either….and what’s more, because of my hedge, I am allowed to own more of those bonds.

Which is important when people are looking for buyers of copious amounts of soveriegn debt. Without CDS you simply wouldn’t be able to sustain the same amount of government debt issuance.

Whilst this in itself could well be considered a bad thing, it isn’t nasty speculators trying to bring down or bankrupt those lovely socialist southern european governments.

They did a pretty good job of that themselves.

And again, the short seller/CDS buyer also becomes the only natural buyer as these things do go higher. Try and ban it and the problem gets worse, not better.

I mean, would *you* lend your own money to the PIGS countries??

@ 11 Suitpossum

Short selling tends to slow market falls as to take profit, the short has to actively buy to get his position flat.

In a fast falling mkt with no shorts, you tend to get much larger moves as no-one wants to get long from a flat position….the much used analogy is trying to catch a falling piano.

There are ways to be short property too…the simplest is simply renting and not owning (and thus as house prices go down, the capital you have is worth more in comparison….not a true short but clsoe enough).

Yes, I have a massive short position in property. Might go long a squat tomorrow.

@ Suitpossum

I you have no property, you are effecitvely short.

You have to rent, but the costs of renting and interest costs of a mortgage are normally roughly equal..so you can to a great extent exclude those costs from the (simple) model.

You are effectively short, as the capital you do have allows you to buy something better if the housing market comes lower.

If you have one property, you are flat to slightly long the market….you need somewhere to live (though it depends on the equity you have in the house)

If you have a portfolio…..you are definately long.

Yeah, I’m not denying that I’m short. Here’s the proof: http://suitpossum.blogspot.com/2011/06/house-rent-blues-on-legal-loansharks.html

If it’s so easy to make money on CDS’s,

(1) why do people sell them? To the extent that buying them is a winning proposition, selling them is a losing one.

(2) why don’t the Greek government buy a load on their debt, then default and make loads of money?

Interesting article, but what I dont understand is why anyone would lend shares or bonds so that the borrower can depress the price, what’s in it for the owners?

They’re long term holders – they don’t care about short-term ups and downs. They receive fees for lending their shares out. Good way to get a bit of extra cash for your portfolio.