It is no great surprise to me anymore when I see the popular financial media overstate the importance of the goings-on of the equity market and all but ignore what is going on in the credit markets. But this latest example irks me all the same.
The markets have been chaotic lately, the papers tell us, because of Germany's decision to implement a limited ban on naked short selling. That may be true ... but it is only part of the story.
**To keep this sort-of brief, I'm going to footnote a discussion of shorting. Those who know about naked shorting can just continue on and not worry about it.
The news coverage of Germany's decision focused on the fact that a limited number of equities in the financial services sector are on the list. Big deal. We in the U.S. banned shorting altogether in some financial services stocks for a time during the worst of the credit crisis and it was not the end of the world. I really do not believe the markets here are selling off because of this announcement; it is small potatoes.
What is a bigger deal, though, is the fact that the naked short ban includes government bonds and credit default swaps. I cannot tell you in exact numbers how significant that is, in part because there is no clearinghouse for these instruments like there is in equities. I can tell you anecdotally, though, that naked shorting is a big part of how CDS trading is done and it is not uncommon in bonds either.
Basically, then, Germany has unilaterally re-written some of the rules of the credit market, and the credit market is far larger than the equity market. That, in turn, can mean chaos for the big trading desks at Goldman Sachs (GS), Bank of America (BAC), Citigroup (C), JPMorgan (JPM) et al. Yet another shot across the bow and shock to the system for these huge financial companies is not good news for the market.
So, ultimately I guess the papers have it right - the short ban is likely behind a lot of the turbulence in the markets. But the "how" really has nothing to do with the ban on naked shorting of equities. Once again, the financial press just misses the story when it comes to the credit market.
**For those who do not know, naked short selling is essentially selling something short with no attempt to locate and borrowing the asset. Normally, when somebody wishes to short an asset (like a stock), their broker finds those shares and borrows them for the would-be shorter. In that arrangement, you never have more than 100% of a company's shares sold short (and practically it will never be 100% because certain holders cannot or will not loan out shares to be shorted).
With naked shorting, no attempt is made to locate and borrow the assets. So, you could theoretically have 200% of a company's shares sold short in the market. Clearly, allowing naked shorting allows for almost unlimited selling pressure, though it works both ways and those shorts eventually have to be covered unless the asset goes to zero.
Although naked shorting in the U.S. equity markets got a lot of attention a few years ago (mostly due to Overstock.com (OSTK) and its very vocal CEO), it is generally not a problem. It is not supposed to be permitted to anybody except market makers, and it serves a legitimate purpose in keeping a liquid market. If a market maker cannot perform a naked short, it can essentially gum up the works and impair trading.
Disclosure - I own shares of JPMorgan
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