In defense of nudity (in speculative markets)

The UK financial regulator, the FSA, recently introduced, without any public discussion and (prima facie) without much deliberation, the requirement that investors disclose short positions in stocks undertaking a rights issue if they amount to an interest above 0.25% of the outstanding quantity of shares.  The US federal financial markets regulator, the SEC, even more recently banned the practice of naked short selling of certain stocks.

A naked short sale is the sale of a stock you don’t own and haven’t borrowed. A speculator sells short if he expects the price of the stock to fall by enough to compensate him for the cost of borrowing the stock or the opportunity cost of assuming a short position in some other way.  There are, of course, other ways to profit from an expected decline in the price of a stock that exceeds what is priced in by the futures markets. Instead of borrowing the stock and selling it, expecting to buy it back at a low price before the loan of the stock expires and to redeem your borrowed stock at a profit, you could acquire a (put) option to sell the stock at or before some future date, hoping and expecting to be able to purchase the stock in the future cash market at a lower price than the strike price of your option.

It appears unavoidable that, whenever prices of financial assets are falling sharply, short sellers will be pointed at as the bogeymen.  Likewise, whenever prices of real commodities are rising sharply, both hoarders/middlemen stockpiling the commodities and long speculators in financial derivatives based on the underlying commodities’ spot prices will be put in the stocks.  Clearly, in speculative markets as in all markets, collusive behaviour, attempts to corner the market or to exercise market power in some other way, and other forms of market abuse (spreading rumours you know to be false and trading on these rumours, e.g. ‘trash and trade’) should be illegal.  But what’s wrong with a naked short position per se?  Is there something obviously distortionary or market-abusive about me entering into a contract today to deliver a stock at a known price one week from now without me owning the stock today or borrowing it today and holding the stock for another week? As long as I and my counterparty are confident that there will be a spot market a week from now in which I can buy the stock I promise today to deliver a week from now, such a transaction ought to be allowed.

What is even more mystifying is that there is no full symmetry in the degree to which short and long speculators are vilified.  The FSA’s new restrictions on short selling are not matched by comparable restrictions on taking long positions in the stock.  The SEC’s selective ban on naked short selling is also not matched by a symmetric ban on naked long buying  – this would be buying stock you don’t owe and have not lent.  Why is this?

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website