By: Justin Matson
A recent unanticipated announcement by the German Regulator BaFin (The Federal Financial Supervisory Authority) has banned naked short sales on 10 financial stocks in Germany and also prohibited naked credit-default swaps on government bonds. Germany, a member of the European Union, acted alone in their legislation and befuddled government officials and investors worldwide. The German Chancellor, Angela Merkel, stated her belief that the euro was in danger which only heightened the pre-existing perception that many individuals hold of a weak European market and euro. The ban has left many investors fearful of the euro’s ambiguous future, however, further analysis reveals more realistic implications.
The first piece of the ban concerning the naked shorting of stocks prevents investors from shorting any of 10 financial stocks without already owning the stock or possessing an unconditional claim to it. Further legislation has also been proposed to extend the ban to all German stocks and euro-currency derivatives. The preceding announcements have sparked impulsive and fearful reactions from many investors scrambling away from the euro, yet does this legislation warrant such behavior?
The act of naked shorting is already illegal in a majority of marketplaces worldwide, including the United States, and many financial officials are surprised that such a ban had not been imposed earlier. Naked shorting in itself can allow for extreme volatility in a marketplace because it grants an individual the ability to short a stock in which he does not have any claim to.
An example below will convey this point.
Ex. To make things simple we will assume there is only 250 shares of AAPL in the market
Short:
Person 1 owns 250 shares of AAPL
Person 2 wants to short 250 shares of AAPL
Person 2 borrows 250 shares from Person 1 and sells them to Person 3. Person 2 is responsible for repaying Person 1 with those shares when prompted.
Naked Short:
Person 1 owns 250 shares of AAPL
Person 2 wants to short 200 shares of AAPL
Person 3 wants to short 200 shares of AAPL
Person 2 and 3 are unable to locate shares to borrow
Person 2 and 3 sells 200 shares each to Person 4
In this example above of a naked short, Person 1 still holds his 250 shares while Person 4’s 400 shares do not actually exist. The company that owns these stocks would therefore be affected because artificial transactions would be taking place with a volume exceeding the possible number of AAPL shares. Person 4 would also be harmed because he paid for 400 shares which he did not actually receive. This example reveals the potential volatility that naked short selling could bear on the market, but on a small scale. Because of this potential for financial hazard this practice is already prohibited in numerous marketplaces worldwide and should not be denoted as an indicator of the fall of the euro like many news outlets have perceived it to be.
The next component of the ban concerns naked credit-default swaps. A credit-default swap is a financial method of swapping the risk of debt default. The buyer of a credit default swap pays a premium to another party which ensures him against debt default. This premium is established based off of the discounted value of the debt and the risk of default. If the debt is in fact defaulted, then the second party would pay a lump sum to the buyer. The seller of a credit default swap receives payments from the buyer, but must pay the buyer if the debt is actually defaulted. Germany’s ban simply prevents individuals from buying a credit default swap in regards to government bonds and debt unless they already own these assets or have an unconditional claim to receive them. Many investors have taken this news to indicate a flaw in the market and an imminent problem that Germany has not yet revealed, however, it should not be viewed in this light.
In essence a credit default swap is a means of insuring one’s self and a naked credit default swap is analogous to your neighbor taking out home insurance on your home. This gives the buyer of the credit default swap, your neighbor, an incentive to burn down your house. This prohibition should only decrease market volatility as it will prevent individuals from speculating on the probability of an event happening e.g. a financial institution or even a country defaulting. By engaging in a naked credit default swap within Germany’s debt, these buyers have an incentive to produce German economic failure in order to profit from it. Aside from this fact, the ban is only applicable within Germany, a relatively small marketplace within the European Union when compared to countries such as England, which should have a minimal affect on the health of the euro. In fact, Analysts at Bank of America mocked the ban by saying, “What’s Germany going to ban next? Rainy days, harsh words, the Macarena?”.
If anything it seems that this ban should create a more stable market and euro because Germany is attempting to establish a system that cannot be readily exploited like the previous one. One of the major underlying flaws of the legislation, however, is that Germany failed to consult any other members of the European Union before enacting their proposed changes which just created market pandemonium rather than market security. The underlying reason the euro hit its 4 year low at $1.21 directly following the announcement of this ban was because Germany’s impulsive prohibitions on the market startled investors. These investors believed this legislation was an early indicator of a sinking euro and European marketplace which caused a decline in the euro which has since rebounded and has remained relatively steady.
The truth of the matter is that the euro had been slowly sinking for a long period of time which can be seen by its 13% decline in this year alone. Events such as the Greek debt crisis and the declining Spanish credit rating have a much higher correlation with the decline of the euro and require immediate cooperation amongst union members. Many financial officials believe that the euro’s viability will depend on sustaining market discipline and effective collaboration amongst the European Union members. This will require members of the monetary union to act collectively as this situation has proved that the actions of one country cannot create stability. Though the markets and euro regressed directly following the announcement of the German ban, it seems that the market responded naively to the overzealous press and that there are more important matters for Europe to address in both the short and long term.
