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Half of Europe Bans Thinking Sad Thoughts About Banks

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Short sale bans. Is there anything they can’t do?

Maybe. But does it matter? If your position is just that "speculation" on stocks is the moral equivalent of puppy-murder and should never be profitable, then you just say things like “let’s ban short sales” and don't worry about the details. You take shorting of bank shares as a personal affront, and your goal is not to have functioning markets but just to prove that you're tough. And your name might be Jean-Pierre Jouyet:

Jean-Pierre Jouyet, head of the AMF, the French securities regulator, said on Thursday night: “They [investors] wanted to test French resistance. This is our response, as always very determined, and it will be so for all those who want to put us to the test.”

But, as we're seeing with new short sale bans from France, Italy, Spain and Belgium, this approach sometimes has problems, because most short selling takes place in an actual world where other things happen too. Like:

1. Sometimes those banks that you want to protect, they need the moneys. This is hard to believe because all European banks are obviously well capitalized and any suggestion to the contrary is just rumor and speculation. But! Sometimes things go wrong. Sometimes banks need to raise money. When equity investors are staying away from them, sometimes they do this by selling convertible bonds or CoCos. And since many buyers of those instruments like to hedge (by short selling), that creates problems:

Another investor warned that the move could “destroy parallel markets, the market for convertible bonds will just collapse”. He added that short sellers were often buyers of new bank stocks issued to raise funds by struggling institutions.

“If you prevent those people being short, sure it’s going to boost the share price for a couple of days, but those guys won’t be around to buy your stock in a capital increase,” he said.

The short sale bans are mostly for just 15 days, but repeatedly changing the rules in the financial markets will have effects well beyond the brief share-price gains. If you're a convertible arbitrage investor, it's now pretty clear that you should never buy convertibles issued by a European bank, because you may not be able to hedge when you need to. Which can't be good for the banks' future capital raising needs.

2. Evil speculators are crafty and have ways to short stocks other than just shorting stocks. And if you don’t ban derivatives, and let market makers continue to short to facilitate client trades, then clients can create net short positions by buying puts and/or selling calls. The regulators have picked up on this time, and are not having it. For example, Spain:

This preventive ban affects any trade on equities or indices, including cash equities transactions, derivatives in regulated markets or OTC derivatives, that has an effect of creating a net short position or increase a previous one, even if on an intraday basis. A net short position means any position resulting in a positive economic exposure to falls in the price of the stock.

Doesn't that seem a little broad? In this world of increased correlation, buying USTs or gold probably has some negative delta to Spanish bank stocks – does Spain want to ban stocking up on gold?

France gets more specific:

3 - Is an investor allowed to create a net short position in one of the securities concerned by using derivatives?
No, investors are not allowed to use derivatives to create a net short position; they may only use derivatives to hedge, create or extend a net long position.

And don't get cute on them either:

6 - Are trades in index derivatives allowed where the basket of securities includes one or more of the securities concerned?
a) Investors exposed to the equity market are allowed to hedge their general market risk by trading in index derivatives. In this context, the AMF accepts the marginal net short positions in the securities concerned that may result from that trading in index derivatives.
b) Trading in index derivatives for any other purpose than hedging general market risk is not allowed unless the resulting net short positions in the securities concerned are offset by long positions.

We wonder how you would test whether a net short position in an index derivative is for the purposes of “hedging general market risk” or for the purposes of "profiting on spreading false rumors" (or other non-legitimate purposes, like hedging specific market risk). Presumably anyone shorting European indexes does so because they don't want to lose money when the market goes down. Even speculators.

More curious:

c) Taking a net short position in one or more of the securities concerned by combining index derivative transactions and other transactions is prohibited. It is therefore prohibited to:
- sell futures contracts on an index whose underlying basket includes one or more of the securities concerned, or
- buy futures contracts on any of the securities included in the underlying basket of the index except for the concerned securities.

Fun fact: because the ban covers creating new net short positions, we read section 6(c) to say that if you’re already short a French index, you can keep your short on, but you’re not allowed to buy non-bank French stocks. (Incidentally this section reads very differently in the original French though the basic intent of not shorting indices and buying back non-financials remains the same.)

3. Some people don’t live in France.

7- Who is subject to the Decision announced in the News Release?
The Decision applies to any natural or legal person, French or foreign, regardless of whether trading takes place in France or in another country, or on a regulated market or not.

The other bans are similarly extraterritorial. We wonder - and are not alone in wondering - how the French, Italian, Spanish and Belgian regulators plan to enforce bans on short selling by foreigners living abroad. But if you're thinking about it, just remember that you don't want to test their resolve. They may not have much in the way of ideas on how to keep capital markets functioning, but they have no shortage of resolve.

French short sale ban – press release
French short sale ban – FAQ
Spanish short sale ban
Italian short sale ban