Wednesday, September 24, 2008

How the short-selling ban could backfire on the banks

How the short-selling ban could backfire on the banks

Short-sellers are being used as a scapegoat for a crisis which they did not create. Regulation is not the answer, says Dominic Frisby. In fact, the proposed ban on short-selling could have some nasty consequences...

Posted by damien @ 11:25 AM (1358 views)
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17 thoughts on “How the short-selling ban could backfire on the banks

  • He didn’t explain the backfiring mechanism.

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  • Upshot is that the government and those truly responsible don’t want the limelight. So throw short sellers to the wolves and be seen to be doing something.

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  • I didn’t think it made sense even. Sounded like his argument is that the hedge funds borrow money from the same banks they are shorting, so any losses from the hedge funds hit the banks as defaults, as opposed to the hedge funds successfully shorting the banks, in which they case they can pay the money back to the bank, which is bust….. Very circular.
    I like the idea that the banks have flooded money to people who bet using that self same money on it being a bad idea….
    As in, can I borrow 20 thousand pounds off you because I want to make a bet you will never see it again.

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  • Cynicalsoothsayer says:

    He does say how he thinks it will backfire at the end of the article, though I don’t entirely agree with him.

    Some short sellers are useful market makers, but some hedge funds speculate with a herd mentality that can make the shares yo-yo in a ludicrous manner. It’s froth, but our esteemed political leaders unfortunately didn’t see it as what it really is: froth. Ultimately the value of the bank shares and hedge funds will head towards what they are really worth, inflation included. Politicians, central banks, the city and wall street can’t stop it, no matter how much taxpayers dough gets thrown at it.

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  • Note the quote from Cgnao near the end of the article. So that’s where he has gone 🙂

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  • The problem is the possibility that shorting party is backed up by such overwhelming financial inertia, as to bring down totally wholesome institution. Market participants would not always afford time to calmly evaluate the situation under horrofic panick. Once the confidence is totally lost, and the insititution has gone under, everything is too late.

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  • I think the point is that:
    Shorting stops as does pressure to drive prices down.
    PIs get optimistic and drive prices up.
    Shorters therefore lose a bomb.
    But shorters borrowed the cash from the bank and so default.
    So banks get in bigger doo doo and SPs drop. [ie it backfires]

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  • But surely they have been banned from shorting a specific list of companies. The first thing this does is to highlight to the world the institutions in the most trouble – this should by rights prompt a sell off of shares.

    Secondly it means that instead of various shorters shorting these companies, they move down their “list of companies to short” until they hit one that isn’t on the banned list. This surely concentrates the shorting power of all the shorters onto a smaller list of companies, that are probably in general smaller companies than those on the banned list – and therefore less able to avoid annihilation when shorted.

    So doesn’t this make it more likely that companies are going to be forced under?

    And aren’t hedge funds all wrapped up in shorting and CDOs and other toxic debt? If I understand correctly, Hedge Funds have been a major source of liquidity (buying and selling the toxic debt) that has caused this problem. Unfortunately the government is trying to re-start the madness. If they harm the hedge funds by banning shorting, they are less likely to see hedge funds injecting any liquidity into the system. In fact, by banning shorting, and making many of these hedge funds make losses, those individuals that invest in hedge funds (include our pension pots) will be more inclined to withdraw more cash – causing a run on the hedge funds – making it impossible for the hedge funds to invest in anything that might actually inject some liquidity back into the system.

    I can’t say I’m surprised, but I think the government have really fugged it this time.

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  • planning4acrash says:

    Short-selling has been banned on a select list of about 170 financial institutions bailed out by the unconstitutional Fe(de)ral Reserve. Short sellers have been given open field day on companies from the productive economy, which will be bought down and be bought for pennies on the pound with your tax money. Same is true for small boutique investment companies and small chain local banks. This is the robbery of the century, of the millennium. We are being robbed blind.

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  • But shorting doesn’t change the share price!!

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  • But shorting doesn’t necessarily or even usually affect the share price at all. I don’t see the problem.

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  • One of the issues is that financial institutions use shorting to hedge stuff like rights issues, which the self same banks are using at the moment to raise cash.

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  • I agree with this guy. The ban of short-selling of financials artificially and temporarily pumps the price of the shares due to the demand produced by the need to cover.

    Furthermore the banks that were lending the shares were adding certain realised profits to their existing, uncertain paper profits but now are simply holding uncertain paper profits. If I were them I’d start selling off the positions of these shares as and when they are returned to me* since I cannot loan them any more and neither can my competition, so they will be doing the same. This can only force prices down.

    * This is a cause of inertia to the downward pressure as short positions already open are allowed to remain open.

    The funds that have the solvency to maintain their shorts during the bounce should rake in large profits, but those with the balls but not the solvency will cause problems to both themselves (obv) and the banks and the markets.

    The ban of short selling is a knee-jerk reaction by regulators it seems – maybe (hopefully!) just to buy themselves time?

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  • Elpapasito – How can you say shorting does not affect the price?!
    Market price is a reflection of how much imbalance there is between those selling and those buying.
    Shorting is selling stock (either borrowed from a holder or naked)
    If traders are shorting then there is more supply than demand therefore prices go down.
    So please do explain how you think shorting does not affect price.

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  • “The rules relating to short-selling have been introduced by uneducated idiots responding to the baying mob.” – agreed

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  • The practice of short-selling is selling a contract to a buyer that obligates the seller to purchase the stock at a later time on behalf of the buyer. It doesn’t involve actually selling the stock (at this point in time). I think the worry is more about what influence short sellers can bring to bear through their other investments.

    Its a distraction; and anyway, short selling is really a contract between two parties involving money and a gamble. The money to be made is based on taking money from someone else.

    I don’t believe short selling really mitigates risk. It just spreads it around a bit more. The cure for our current ills is for those who run businesses to act more sensibly. This is probably the best way of mitigating risk. Profits should be based on who produces more at a cheaper price; not the result of a gamble.

    Also on the subject of backing currencies with something; what if tomorrow we invent a means to make gold from lead. What happens to our backing then? Also; how do we keep supply of the backing in step with the expansion of the world economy? What if tomorrow, instead of finding a way to generate gold, the world’s gold mines simply run out. Does this mean that the proportion of currency to the size of the world’s economy shrinks? IE everything will cost less (by some definitions; a recession). In other worlds if you run out of supply for the backing; then the supply of currency stops, and therefore the growth of the economy stops.

    So ultimately why throttle your economic development arbitrarily against the supply of a mineral?

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  • You have to understand the the lender of the stock to the shorter (eg a bank) is not usually the beneficial owner. Hence they collect a fee for lending it out but suffer no consequence from the subsequent fall in value. Banning shorting on a few stocks won’t change this fundamental flaw.

    The argument that shorting has little effect on price is that it is generally a small portion of the trading. As HBOS collapsed only about 2% of the stock was being shorted. 98% was being traded in the normal way and was driving the price down.

    The govt banned it as a PR move, not because it will help.

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