July 19, 2008
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?
I hope the last sentence was meant as a joke. Clearly, if you buy a stock both sides have the means to settle the bargain assuming the seller is not a naked short and the buyer is not destitute. A naked short on the other hand has no assurance of being able to settle the bargain since to do so relies on his ability to find the stock that he sold.
By the way, I agree that shorts should not be demonized. They’re important to an orderly market.
Posted by: Tom Lindmark | July 19th, 2008 at 10:11 pm | Report this commentDon’t you realize that the attempts to demonize short-sellers represents the usual Government regulatory pandering to pressure brought to bear by top executives at publicly-held companies who do not want anyone to have the option of doubting their “infallibility” in raising the stock price through their actions. If short-selling is not allowed, then there is less legitimate pressure on stock prices to reach an appropriate, market-clearing level that reflects the full assessment of the prospects of a given company. That the head of the SEC in the USA makes an issue of this to begin with and then proceeds to propose rules to limit short-selling is a clear indication of his limited and utterly biases mindset. But then again, he is an appointee of the current Administration that is among the dumbest and most venal ever.
Posted by: Wendell Murray | July 19th, 2008 at 11:34 pm | Report this commentRe Tom’s comment. I don’t think the reason for (selectively) banning naked shorts is concern on the part of the regulator that the seller mey not be able to find in the spot market the stock he sold short & naked. It is instead the fear that sales, short or short and naked, will push down the price of the stock. In most jurisdictions there are financial consequences (as well as reputational ones) if you sell (short) but cannot deliver. That should be sufficient. The same applies to buying but not having the means to pay on delivery.
Posted by: Willem Buiter | July 20th, 2008 at 12:16 am | Report this commentIs there a problem naked shorting a stock where there is no intention to deliver shares?
Is there a problem naked shorting a stock where there is no possibility of acquiring shares to deliver shares?
Both of those situations have happened. Neither would be possible if naked shorting were banned.
Posted by: Max | July 20th, 2008 at 9:22 pm | Report this commentA simpler question, and one easily understood by anyone, is this:
Why are the SEC regulations which we have had for decades suddenly insufficient, but only for the next 8-30 days, and only for the stocks of certain financial firms?
It’s almost like the authorities are in a panic. But surely THAT can’t be right. I just heard Paulson telling me our banking system is “fundamentally sound”…
Posted by: Nemo | July 21st, 2008 at 2:59 pm | Report this commentIt is extremely weird as to why SEC banned naked short-selling of selective stocks instead of stocks in the whole market. Clearly, the policy is to prevent the decline in stock prices rather than the issue of non-delivery of shares by speculators if the stocks have sufficient free float. Nevertheless, the fear of non-delivery is the task of the broker, who has to manage its client’s account appropriately.
Posted by: Michael Khor | July 21st, 2008 at 9:34 pm | Report this commentDuring, the Asian financial crises when policy makers revoked short-selling the emerging markets were accused of cronyism, rigged market and lack of transparency, etc. How do we classify the SEC banned on selective short-selling?
It looks panicky and narrow. There is an argument against naked shorting, and one which aligns more with CFTC’s Modernisation Act of 2000. Sec 109 prevents trades which do not ultimately end in the execution of the contract, ie bans against “fictitious trades” and those without bona fide intent to execute. I came across this looking into IFPRI’s rather casual report on how it could work the futures market, assuming that was the source of price rises in food commodities, other than supply and demand, and which could be gamed to ensure food supply. There is perhaps a principles-based regulation to be considered elsewhere.
Further, I agree with poster Max, and good note from Nemo, that the selective list of the Cox 19, for whom no naked shorting is allowed, is inappropriate. The delineation is wrong. Whether the practice is wrong, or the regulation is inadequate, is not addressed. To single out 19 institutions suggests a series of things: 1. this is the right answer to the apparent porblem, 2. subsequent government oversight will be better, 3) these institutions are victims somehow of shorting, rather than overleverage and lousy balance sheet, for which proof ought to be supplied and 4) that they can still do it themselves, mostly, but get by with a little help from their friends… cue req Beatles tune. Net result? CDS premia go thru the roof. No wonder.
Having been involved in public policy for 15 years, including thru the Asian crisis, it just sounds like Jeff Goldblum’s character in Jurassic Park II: protaganist “We’re not going to make the same mistake again”, Goldblum “No, no, you’re going to make a whole lot of new ones”.
M
Posted by: Matt | July 22nd, 2008 at 5:41 am | Report this commentI agree that effective rules to discipline failure to deliver in settlement (eg buy in rules) are more appropriate than a ban on naked short selling if that is the regulatory concern. But I also agree that it probably isnt. My guess about the SEC’s intentions are:
Posted by: David Rule | July 23rd, 2008 at 3:55 pm | Report this comment- a shot across the bows of the short sellers to make them fear further regulatory action and perhaps instigate a short squeeze (which has happened apparently to some extent)
- perhaps an attempt to constrain high velocity/day traders who may sell stocks short with the intention of closing out the position before settlement; that may be on the view that very short-term volatilty in share prices is exaggerated by such momentum traders (as opposed to traders taking short positions on a longer-term, fundamentals-based view) - I would be interested in whether there is any hard evidence that this is true?