Germany's Naked Short-Selling Ban:

by: Karl Denninger May 25, 2010


Karl Denninger


The German government is planning to ban the naked short-selling of all German stocks listed on the country’s exchanges in a sweeping enlargement of last week’s contentious bar on the naked short-selling of some securities.
To be clear: Naked short-sales are already illegal.

A bit of explanation is called for here. You can't sell something you don't own. Therefore, to sell short you have to first acquire what you wish to sell. To do this you borrow it from someone else. For example:

"A" owns 100 shares of IBM stock.
"B" wishes to sell short 100 shares of IBM stock.
"B" therefore borrows "A's" stock, replacing that stock with an IOU for the 100 shares, and then sells them to "C."
There are still only 100 shares of stock. "A" is entitled to whatever dividends would normally be paid by those 100 shares even though he doesn't have them any more, and "B" has to make good on that. "C" has the physical shares and gets the cash dividends that are paid on them, if any.

If "A" wishes to sell his 100 shares "B" must return them. He must return them because the IOU "A" has is callable on "A's" demand, irrespective of the price "B" might have to pay to acquire them!

That price might be very high if there are no willing sellers at a "reasonable" price when "B" has to repurchase them. But that doesn't matter - "B" agreed to this when he entered into the short sale. This event, called a "short squeeze," is one of the risks of selling securities short - since you don't own them and have to borrow them the person you borrowed them from might want them back at any point in time - and you're obligated to deliver if that happens, even if it bankrupts you (and sometimes it does).

Unscrupulous people can and have gotten around this problem. How? By not actually having acquired the securities they allegedly sell short.

Hang on a second ... how is that possible?

Today, it's very possible. "Back in the day" it was pretty tough, since stocks were represented as physical pieces of paper. When the trade settled you had to deliver the physical shares.

But today when I place an order to buy a stock my broker says "ok, you did it," takes the (electronic) money out of my account and puts the (electronic) shares in my account. It's all a record in a computer - no physical evidence of those shares pass from one hand to another.

Stocks settle at "T+3," that is, the trade date plus three days. Why? Historically this was because certificates had to be mailed. But today, options and futures settle either same or next day, and stocks don't.

So what happens if I "short" some stock but didn't borrow it first?

Now "A" still has his 100 shares (instead of an IOU) and "C" has his 100 shares. "B" is "short" 100 shares.

Wait a second ... "C's" shares don't really exist in this case.

This is in fact a criminal offense. The specific crime is called "uttering", which is the offense of presenting a counterfeited or forged document to another person with knowledge of its forged nature.

The company who has its bonds or stocks forged and uttered is the harmed party. In addition the party who bought said naked-shorted shares or credit instruments without knowledge of their falsity is also harmed, as they have bought something that is in fact worth nothing as it doesn't really exist.

Short selling banned in Germany
EU arm calls for joint action in aftermath of German bans
U.K. regulator says steps don't cover German institutions outside of Germany
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By Polya Lesova, MarketWatch

FRANKFURT (MarketWatch) -- The European Commission called on Wednesday for coordinating regulatory actions across the union, a day after Germany unilaterally banned naked short-selling of certain assets in a bid to reduce financial volatility.

Separately, German Chancellor Angela Merkel urged adoption of Europe-wide rules, saying there is an "existential threat" facing the euro. "If we don't avert this danger then the consequences for Europe are inevitable, because if the euro is failing, than Europe is failing," she said.

Michel Barnier, the European Union's internal market commissioner, said he fully understood German concerns about the impact of naked short-selling -- the practice of selling shares or other assets that aren't owned or borrowed.

Reuters
German Chancellor Angela Merkel delivers a government statement on the handling of the European debt crisis in the Bundestag lower house of parliament in Berlin May 19, 2010.

"These measures will be even more efficient if they are coordinated at the European level," Barnier said, referring to the German ban.

"It is important that member states act together and that we design a European regime to avoid regulatory arbitrage and fragmentation both within the EU and globally," he said.

Germany's decision late Tuesday to ban certain trading practices caught financial markets off guard as analysts questioned the timing and effectiveness of the move.

"It was certainly a surprise and it's just showing exactly the reason the euro is that weak," said Heino Ruland of Ruland Research in Eppstein, Germany. "The European monetary union is not able to communicate and is not able to work together."

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Along these lines, EU finance ministers are due to meet on Friday -- yet already divisions are forming.

Christine Lagarde, the French finance minister, said France doesn't plan to ban naked credit-default swaps, since it's a very narrow market, according to media reports.

And in the U.K., the Financial Services Authority said that Berlin's actions don't relate to branches of German institutions outside of Germany -- good news for Deutsche Bank /quotes/comstock/13*!db/quotes/nls/db (DB 57.99, -2.20, -3.66%) /quotes/comstock/11e!fdbk (DE:DBK 46.04, -1.37, -2.88%) , whose main trading floor is based in London.

The measures announced by Germany late come as investors have been spooked by the high levels of sovereign debt in the euro zone and Greece in particular.

The German move rattled markets across the globe Wednesday, sending the euro /quotes/comstock/21o!x:seurusd (CUR_EURUSD 1.2222, -0.0122, -0.9885%) and commodities prices into gyrations as stock markets in Europe and Asia fell.

Strategists at Deutsche Bank captured the mood in the markets: "Just when markets were slowly regaining some poise, yesterday saw a strange political announcement that sapped strength from a still fragile market."
The ban

Late Tuesday, Germany's Federal Financial Supervisory Authority, known as BaFin, announced that it has prohibited so-called "naked" short-selling of some assets -- measures that will remain in force through March 31, 2011.

BaFin banned naked short-selling in shares of 10 German financial institutions, including Allianz SE /quotes/comstock/11e!falv (DE:ALV 78.70, -1.87, -2.32%) , Commerzbank AG /quotes/comstock/11e!fcbk (DE:CBK 5.71, -0.17, -2.81%) , Deutsche Bank and Deutsche Boerse AG /quotes/comstock/11e!fdb1 (DE:DB1 50.51, -1.26, -2.43%) . See analysis of impact on stock prices.

The regulators also banned naked short-selling of euro-zone bonds and barred the purchase of credit-default swaps without owning the underlying security.

A CDS contract can be used as an insurance policy against the default of a bond or loan, but German regulators believe that speculators have been using CDS contracts to place bets on the creditworthiness of a country, thus triggering volatility and market disruption.

BaFin cited "the extraordinary volatility" in debt securities issued by euro-zone countries, adding that euro-zone CDS spreads have widened significantly. These "excessive price movements" could threaten the stability of the whole financial system, BaFin said.

Analysts noted the decision comes as Germany's parliament debates its contribution to the 750 billion-euro bailout plan announced by the European Union and the International Monetary Fund.

"In view of getting parliamentary approval for the legal act covering Germany's 148 billion euro financial contribution to the 750 billion euro support package, the BaFin announcement seems likely to help to shore up support in the Bundesrat [upper house]," said analysts at Barclays Capital.

Polya Lesova is reporter for MarketWatch, based in Frankfurt.

http://www.constructionweekonline.com/article-7870-dewa-to-award-iwpp-consultancy-contract-in-june/

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