Short Selling Bans — or When Political Expediency Trumps Reason

Earlier this month France, Spain, Italy, and Belgium placed temporary bans on short selling of some financial stocks in an effort to stabilize markets. Greece and Turkey had already placed similar short-selling limitations on some financial shares. Last week, Spain and Italy confirmed that their bans would last until 30 September, while France and Belgium refused to give an end date to their short-sale bans. If this all sounds familiar to you, it is because back in 2008 regulators on both sides of the Atlantic placed similar limits on short sales — largely to very little effect.

This latest round of own goals is the consequence of deep-seated concerns with many of the financial institutions in these markets. Investors are rightfully wary about the magnitude of their sovereign debt holdings and are seeking ways to either protect themselves from the effects or, heaven forbid, to be one of the small group that might benefit on behalf of their beneficiaries. In response, regulatory authorities are attempting to arrest the negative sentiment by banning short sales.

CFA Institute has long held — and advocated to regulators and legislators, alike — that short selling is not only a legitimate investment activity, but one that enables markets to quickly and accurately adjust securities prices to reflect investor opinions about valuation. For example, short sellers may help to temper market bubbles before they get too large and systemically risky.

Naked short selling is a different animal altogether, however. We consistently express the view, supported by members, that such activity should not be allowed and should be prosecuted under existing rules and statutes. Naked short selling undermines investor confidence in a number of ways. First, naked short sellers deliver unauthorized shares to uninformed buyers, thus depriving the buyers of the basic benefits of ownership, such as voting and dividends. Such trading also may subvert the appropriate workings of the market by avoiding certain restrictions applicable to those who deliver shorted shares on time.

By focusing on banning short selling, however, politicians are unintentionally demonstrating a lack of understanding about such trading and throwing a spanner in the efficient working of financial markets. Over time, this simply adds to uncertainty in the eyes of investors, who have to anticipate when a legitimate financial practice (short selling) will become temporarily illegal due to changing political winds.

Markets would be better served if politicians focused on greater fiscal transparency, on the one hand, but let legitimate short sellers play their essential role on the other. By embracing this nuanced position of differentiating naked short selling from legitimate short selling, politicians would actually look well informed, and more importantly, they would be right.