Europe’s Short Sale Ban May Be Slightly Less Terrible Than They Want You To Think

Europe is doing various terrible things about short selling today, and go talk about them in the comments, but this whole thing is really boring isn’t it? It’s like the “price gouging is grrreat” arguments that spring up like weeds after natural disasters;1 there’s the thing that politicians do to Convey Emotion and then we over here in the blogs are all “aha that thing is emotional but wrong!” and we all feel good and rational. So let’s, there’s nothing to stop us, we are in fact good and rational and the politicians are in fact emotional and wrong, as we and they always are, so there’s nothing wrong with patting ourselves on the back a bit when it’s demonstrated particularly clearly. I guess.

So, yes, Spain is continuing its ban on short sales of stock for another three months, to reduce volatility, though it seems to have increased volatility,2 because that is how you pantomime “deep concern” to … someone … and “blind panic” to the financial markets. And Europe more broadly has a ban on (1) naked shorting of stock and (2) naked CDS positions that goes into effect today; some things to think about that include:

One slightly different read of the pan-EU rules is that they are less about their ostensible emotional purpose – “don’t anybody say anything mean about European governments or banks” – and more about market-structural stability. Saying “I will ban naked short selling because greedy evil speculators bwahaha” sounds nice, but banning naked short selling just requires you to locate some shares to borrow before you sell short. This is a pretty sensible thing to require because if you don’t have it then there are settlement fails, and people who think they have shares don’t have shares and can’t vote or get dividends or whatever, and it’s a big mess. The US has kind of banned naked short selling for ages and it works fine and we still have short selling; Europe will live.3

Banning “naked” credit default swaps is a much nastier piece of work, because it pretty much destroys liquidity in the CDS market. The regulations allow you to buy CDS protection only to hedge a long exposure; they are loose enough to let you hedge any correlated exposure – not just government bonds – and I initially read that to say “everything is correlated to everything, no problem!” but in fact they require a 70% correlation and some sort of story about why you’re correlated instead of just “meh, statistics.”4 Justifying your existence every time you trade CDS is a higher hurdle than just finding a borrow. So you won’t trade CDS much, and liquidity will go away and it’ll stop being a useful market, with bad effects for the thing it hedges. If you can’t hedge Italian bonds you won’t buy Italian bonds, I guess, though (1) if you hate them that much why buy them in the first place and (2) the fact that net notional of Eurozone sovereign CDS is under 1% of notional of Eurozone sovereign bonds might raise empirical questions about the centrality of CDS to the government bond market.

Anyway, though, markets don’t go away just because you ban them. I enjoyed this IFR article immensely, in which I learned that people who’d formerly be betting against Italy or whatever by buying CDS is now instead selling listed government bond futures, which are booming:

“The growth in futures volumes is unbelievable,” said one senior credit trader. “The same short interest still exists – economically it’s identical. If you thought the short interest was hurting the market then it makes no sense to say cleared derivatives are good and OTC derivatives are bad.” … Bankers have expressed bemusement at the clear inconsistencies in the new rules, with regulators allowing futures while shunning CDS shorting, although some reckon it is yet another sign of regulators favouring exchange-traded markets over OTC business.

“Futures are cleared, and people like that. It will also stop the “big bad” OTC guys doing their stuff,” said the senior credit trader.

You want to hedge Eurozone government debt, or more to the point bet against it, just sell futures. You get your economic exposure (short government debt)5; Europe gets … clearly not whatever joy it got out of preventing you from shorting government debt, so, something else? Something like “forcing derivatives to be public, cleared, and exchange-traded rather than secret, bilateral, and OTC”? That seems like something that lots of governments want.

You could even read the super-nitty short-position disclosure requirements – where you need to disclose every, like, 0.0001% change in your short position or something – this way. It’s easier to get blown up short than long; losses are unlimited and so forth. So why not let regulators know who is at risk of getting blown up? I don’t really believe this – I think that the short disclosure rules have the primary intent and effect of annoying short sellers – but I guess there’s a case for it.

I dunno. The Spain short-sale ban is indefensible, as is putting the pan-EU rules into effect without finalizing the exemptions. But I wonder if some of the rest of this is just European regulators doing a lot of what US regulators have already done (requiring locates for short sales) and a bit of what they want to do (moving OTC derivatives to transparent, exchange-traded, cleared forms). While, of course, combining it with the sort of anti-speculator rhetoric that everyone loves.

EU short selling rules spark confusion [FT]
Spain extends short-selling ban of stocks 3 months [MW]
The EC can claim “success” in CDS regulation [Sober Look]
Government futures boom on CDS ban [IFR]

1. I for one enjoyed reading “my view was already conventional wisdom and barely counted as a Slatepitch” in Slate. Also, Felix Salmon is anti-gouging, because he values your time less than your money, which you might ponder productively.

2. Sort of a mixed bag though I think consensus is that allowing short selling reduces volatility. Anyway the ban went into effect in July, and the orange line is volatility; see if you can extract anything interesting from this:

3. Here if you care is a Latham client memo on the differences between the US and new European regimes.

4. See Article 18 here; 18.1(a) has the 70% correlation requirement (trailing 12+ month corr) and 18.1(b) has the “qualitative correlation” test which is bonkers.

5. It would seem to me that the exposures are not identical and that futures are a poor substitute for CDS, particularly if you actually want to hedge credit, meaning that futures are better as a way to make naked bets against Europe than to hedge your actual bonds. So that’s kind of bad for everyone.

(hidden for your protection)
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5 Responses to “Europe’s Short Sale Ban May Be Slightly Less Terrible Than They Want You To Think”

  1. Not a CDS trader says:

    Serious question: When a trader buys CDS, does he/she actually know anything (or care) about the credit quality of the counterparty, or does one simply assume the counterparty won't do something stupid (i.e., AIG) and will have assets?

    • Beerio says:

      Presumably some former teacher of yours told you there was no such thing as a stupid question. Thanks for proving them wrong.

      • Not a CDS trader says:

        Your response is clever but uninformative. Notwithstanding its stupidity, it's still a "serious" question, i.e., one to which a substantive response from an actual CDS trader would be insightful (for me at least). I assume behavior (if only pricing) changed post-Lehman/AIG, but I don't know that. Hence the question.

        • Beerio says:

          If you're trading CDS with a counterparty you've normally got an ISDA and CSA in place with them (although it's possible to do a long-form confirmation). As a result all your credit concerns have been previously addressed and losses or gains on the contract are calculated daily and margin is posted by the counterparty out-of-the-money so if the counterparty defaults then you already have their money (up to the current value of the contract). So to answer your question, it is not something you tend to consider at the time of the trade for CDS, because you are normally fully collateralized.
          There are some entities who won't post collateral (supranationals/central banks etc) which makes things more complicated but you're not typically concerned about their credit quality.
          Interest rate swaps are different and you do charge people for credit…

    • guest says:

      When a trader buys equity, does he/she actually know anything (or care) about the value of the company?

    • They Be Partin says:

      Yes, the trader does care about the counterparty – almost as much as the actual CDS trade itself, they're somewhat intertwined.

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