What has changed?
Germany has banned naked short selling of euro-zone government bonds, the credit default swaps associated with them and shares in the country’s 10 leading financial institutions. The ban will run until March 31st, 2011.
What’s the difference between short selling and naked short selling?
Short sellers bet on a decline in share or asset prices. They do so by borrowing the share, selling it at the current price and buying it back at a later stage, hopefully (for them) at a lower price. A naked transaction is a short sale that has been carried out without first borrowing the shares or at least ensuring that the shares can be borrowed.
What is a credit default swap (CDS)?
A CDS resembles an insurance policy, with buyers protected in the event of a bond default. They can be purchased for all kinds of bonds, but German policymakers are targeting the sovereign CDS market.
Why does Germany want to restrict their use?
Finance minister Wolfgang Schaüble said the “great worries” caused by speculation on EU bonds necessitated the ban, while the German regulator cited the “extraordinary volatility in government bonds in the euro zone”. Last week’s gargantuan €750 billion rescue mechanism for troubled euro-zone states has failed to prevent the euro from hitting a four-year low, and German chancellor Angela Merkel yesterday warned the single currency was in “danger”, with potentially “incalculable” consequences.
Is there evidence to suggest that speculative CDS activities have exacerbated the euro-zone crisis?
In March, a report by the German regulator found “no evidence of massive speculation against Greek bonds”. For the week ending May 7th, there was just $7.7 billion (€6.22 billion) in outstanding CDS on Greek debt, compared to $7.8 billion a year ago. EU government bond spreads “moved before CDS, widened more than CDS, and remain wider than CDS”, according to Tim Backshall of Credit Derivatives Research. Instead of banning sovereign CDS, “they should propose banning the sale of any government bond once it has been bought”, he scoffed.
So why is Germany going down this road?
Populist reasons, perhaps – Merkel is under pressure after recently losing a key regional election.
Are other countries likely to follow?
Eddy Wymeersch, chairman of the Committee of European Securities Regulators in Paris, said a similar Europe-wide prohibition was “doubtful”, while French economy minister Christine Lagarde said naked shorting of European debt was useful for “liquidity needs” (French banks are among the biggest CDS writers in Europe). Irish, Dutch, Finnish and Swedish regulators have said they are not considering following the German example.
How have the markets reacted?
Badly. Indices in Germany, France and the UK all fell by nearly 3 per cent, while US and Asian stocks also tumbled. The Iseq was down by more than 4 per cent. The cost of insuring against European sovereign default initially fell sharply, only to rise again in a volatile trading session. The euro fell below $1.22 in early trading, while perceived safe havens, such as the US dollar, the Japanese yen and gold all rallied. Analysts were almost uniformly scathing.
Why the negativity?
The unilateral action added to fears that European policymakers remain divided and smacked of panic, critics alleged. Others saw it as a mere distraction from the real debt problems plaguing Europe, while there is increased chatter about a “Lehman II” for Europe’s banks.
Another Lehman? What’s wrong with banning these naked short sales? Isn’t it banned elsewhere?
Yes. The timing, allied to the fact that only financials have received this protection, seems to be the problem. “It raises the question as to whether the German regulator knows something the market doesn’t,” as a Rabobank analyst put it. “If there is a secret here, it can’t possibly be a positive one.”
Which are the 10 German financial institutions affected?
Aareal Bank, Allianz, Commerzbank, Deutsche Bank, Deutsche Boerse, Deutsche Post, Generali Deutschland, Hannover Re, MLP and Munich Re.
It seems reminiscent of the regulatory crackdown in 2008.
Back then, financial fragility and suspicions of dirty dealing caused temporary restrictions to be placed on short selling around the world. Initial share price falls at Anglo Irish Bank and HBOS, among others, were initially greeted with allegations of market manipulation. Calls for such restrictions tend to be common in times of crisis, whether it be the dotcom implosion of 2000-2002, the 1990s Asian crisis or the 1930s Depression.
So it’s war between the regulators and the market?
Apparently so. Angela Merkel recently warned that there was a “battle of the politicians against the markets”, adding that she was “determined to win”. Veteran investor Jim Rogers, however, cautioned that the market has “a lot more money than any government” and would ultimately “come out way ahead”.