Short Selling Ban May Kick Off Market Liquidation

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The US$700 billion Paulson plan is barely three days hold. Yet you already get the sense that it is failing in one essential objective: restoring investor confidence in the global financial system. This week, as shocking as it is to say it, could be even more momentous (and destructive) than last week.

Keep this one point in mind, we have moved beyond debates about asset valuations and whether this is a liquidity crisis or solvency crisis. This is now a test of whether ordinary investors and savers believe the financial system is on the verge of a collapse.

That’s it, plain and simple. It’s tempting to think we’ve averted the crisis and are now beyond it. Most of the time, investors ride the ups and downs in the market and go about their normal business.

But this is not most of the time. The action in the money markets last week made it clear that investors have lost nearly all confidence in the share market and in the regulators of the financial system. They are moving to cash.

If the Paulson plan fails to restore confidence, the next logical move by governments is to close markets altogether. Think about it. First, the regulators ban short selling. This squeezes the bears to cover and sends markets soaring, at least for a bit. But if it doesn’t work, the only real intervention left is to close the market altogether and take a bit of a holiday.

But for now, we’ll have to see how markets reaction. The first indications are: with indecisions. The ASX delayed its opening this morning so that ASIC could clarify its new policy on short selling to market participants. That policy changed twice over the weekend. First, ASIC joined the U.K. and the U.S. in banning naked short selling.

It didn’t stop there. Whereas the U.S. has banned short selling of any kind on financial stocks to halt the collapse in share prices, ASIC put a blanket ban on shorting of all Aussie shares, full stop. The regulator was apparently concerned that leaving open the resource shares to shorting by global hedge funds was not prudent.

The policy goal is obvious: halt falling share prices by shooting the bears in the head. The intended consequence was achieved in London on Friday, where shares were up 9%. But look out for the unintended consequences.

It’s not just bears who short sell. Hedge funds, by definition, hedge long positions by going short to cover their exposure. Remove their ability to hedge and you invalidate the logic of the trade. In other words, if hedge funds can’t go short, they might not go long either.

The result? After a huge short-covering rally, we suspect some stocks will go no bid. After all, who’s going to want to go long in this environment (especially if you can’t hedge your risk)? Markets are only markets when traders and investors are willing take up opposite views of what’s going on. This is what makes markets, the willingness to take the other side of the trade.

By eliminating short seling, the regulators insure a short-covering rally in the short term. But in the long term? They’ve actually made the market even riskier. You have one remaining choice: long only, or out of the market altogether.

We reckon a lot of people will chose to liquidate their longs and get into cash, rather than being long only at a time like this. The irony then, is that the ban on short selling may actually instigate the market meltdown it’s designed to prevent. Perverse, but perhaps true.

Institutional investors do have the alternative of hedging their longs in the options markets. Look for increased volume on put options. But this trade is rather obvious too, and the premiums on put options would be steep at this point. Again, the sensible (as well as panicked) position is the same: it is better to be out of the markets than in them.

Frankly we’re not sure what would reverse this sentiment. But it’s not our job to engineer sentiment, only to read it. Right now, confidence is on a knife’s edge. And by banning short selling, quite unintentionally, Aussie regulators may have done precisely the thing to kick off a week of full-scale liquidation in global share markets.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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8 Comments on "Short Selling Ban May Kick Off Market Liquidation"

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Ross
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Thanks for the commentary, especially for pursuing the view of needing to separate from those trying to “engineer the sentiment”. To perhaps paraphrase you “Tactical rather than strategic times”.

charles
Guest

While accountants mark to market short selling in dangerous in a bear market as it creates a damaging difficult to stop negative feedback loop. Short selling however highly desirable in a bull market as it just might keep the horses at bay.

As we have a serious bear market the Australian regulators have done the right thing, and as the bull will return I am sure the ban will be lifted.

Ademac
Guest
From my perspective i think this ban is a bad thing. All i hear is the masses crying “Do Something!!!!” You forget the market does one of three things, up, down and sideways. Now the powers that be have “done something” they have removed one of the markets options so now the market can only go up and sideways. Oh wont the masses be pleased. Bring on the greater fools who think this is a valid solution. I have been sitting on the sidelines for the past six months cheering on the falling market. I loved it every time if… Read more »
Coffee Addict
Guest
Good analysis Dan. Few commentators have (until now) started assess policy motivations, the reality that (having got to the point of collapse) there is little key policy choice and the long term downsides. I should add is that the Fed is not actually trying to bail out the market (as many punters assumed during the rally). A full bail out would indeed cost a few trillion but this is not going to happen. The Fed will now be hoping that most of the adjustment will now happen through long term inflation. US voters will blame the next government for this.… Read more »
Matt
Guest
Interesting take Dan, i too am fearful at the depths our regulators are now trying to “engineer sentiment” in our market. Ironic isn’t it, that the one thing we need in credit markets has been taken away from our stock exchange. However, without the proper means to regulate market activity, the asx has previously been powerless to act against collusion between Hedge funds, and the run on of stocks that have obviously been targeted. I guess we have to think of it as if there is a melt down, only the strongest companies will survive, much like what SHOULD have… Read more »
Crazyfist
Guest

Hey remember that American express ad?
Traveller: Mr Wong Mr Wong,I’ve lost all my travellers cheques!
Mr Wong:Oh What kind were they?
Traveller: American express
Mr Wong: American express? Don’t worry it’s not you who have lost them;)
The planet is also melting so where’s Noah when you need him? Or more importantly, who is going to build the next arc? I’m looking at buying shares.
Any suggestions?

The Outback Oracle
Guest

Our debts are so large, our situation so critical, that makets, always and everywhere must go up or we are totally wrecked!

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