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Early May 19, 2010, the German “authorities” banned naked short-selling of financial institutions, euro debt instruments, and cds’s. Dude! That’s really going to help! For details on what this high-finance heist is and how it will affect the markets, read on. What Is Naked Short Selling, Anyway? First of all, what is a “naked” short sale? This stuff is all Greek to most of us. A naked short sale is a sale of something you don’t have (that's the “short” part) without the protection of an option or other counterbalancing asset. You're selling without covering your risk with something other than cash—that's the “naked” part. To see what this actually means, consider imaginary “Stock X,” trading on a German stock exchange. You have many choices available in a free market. You can purchase the stock. You can sell the stock. You can also buy or sell various options on the stock. In very basic terms, if you put in a “buy” order on a stock, you increase the demand for that stock and exert some upward pressure on the stock market indexes. Government officials love this since it makes everybody feel richer if the stock market goes up, and if they feel richer there’s less likelihood of voting out the people in charge. They complain less about taxes, too. Government's don’t like you to sell stuff, though, for the same (converse) reason, as this causes market prices to go down. Although in “normal” times (defined as a bull market in stocks) they don’t really care. In a rising market it's a little thing. What hedge funds generally do can be a little more complicated. They often buy a stock and at the same time buy a “put” option. A put option is the right to sell that stock at a given price. So if you buy stock X at $10 and buy a put option to sell the stock at $10, you are protected if the stock goes down. This makes a lot of sense because you are wanting to invest money with as little risk as possible, and the put is just a form of insurance. It works in the reverse, too. You can sell a stock you don’t own (sell it “short”). The idea is, you think the stock will go down in price, and you plan to buy it back later at the lower price. If you sell at 10 and buy at 5, you make a profit regardless of which you did first. And this is allowed and actually a good thing because it helps make the market more “liquid.” That is, it makes it easier for other people to buy in, or sell out, of the market when they want to do so, which reduces everybody’s risk. Allowing people to get in and out of the market is absolutely essential to the long-term operation of the free market. Trapping people in the market is a good way to destroy the market. The way you sell short is by putting up a sufficient deposit (called a “margin”) to cover the possibility that the stock will rise in price after you sell it but before you buy it back. If the price goes up too much, you may have to add to that margin or buy the stock back sooner than you had planned, so this is risky for the individual but totally understood by the market. There’s nothing wild-eyed or radical about shorting stocks, in other words. It is a normal, beneficial market activity. When you sell a stock short, you can do it either “naked,” or you can buy “cover.” Naked means that you rely on the margin you put up. It also means, crucially during times like this, that your short sale acts as a simple reduction of stock demand exerting its modicum of downward pressure on stock prices with no off-setting upward pressure. Again, this is what government officials hate. Or you can buy “cover,” which is the opposite of the put insurance-type protection I mentioned above. That’s
called a “call option.” The people selling you the call option don’t have to buy the stock in order to sell you the option (that’s called “naked” option selling), but they usually do, in fact, create elaborate stock and options purchases. They are simply looking for small nibbles off of a lot of different cakes. So to summarize, if you do a naked short sale you are selling a stock without creating any counterbalancing market force. You are relying only on cash to protect you. And this creates some downward pressure on stock prices of the item you sold because you are creating “supply” without an off-setting addition of “demand.” Why Ban Naked Short-Selling? Since short-selling (naked or otherwise) is a standard, well-understood and beneficial process, why would it be banned? It goes back to the creation of selling pressures without buying pressures and the desire of those in power to make the market look good. In theory, it would be possible for sufficiently rich financial players to short a company to death. They could keep selling more and more shares short, driving down the price and creating a rush to the exits. Anybody looking at that process would be reluctant to help finance the company because of its plummeting share price, and the company’s ability to raise capital by selling shares would likewise be damaged. It can happen, and it does happen sometimes, especially when national banks around the world have been irresponsibly creating huge oceans of “hot” money. But it almost never happens for large, healthy companies, and the thought of naked short-selling having any real impact on the ultimate health of a currency is ludicrous. The currency markets are enormously too large for that to happen. However. When you have a declining market or shares, shorting can hasten that process, and this is actually good since it reduces the amount of time that the market is uncertain about the value of the asset in question. That allows people to pick up the pieces and start making things better. On the other hand you can somewhat slow the decline by making it harder to get out of the market. You can make it easier for bank officials to sell their shares to suckers so the bank officials don’t have to take the losses, and if you’re a political leader you can slow down things long enough either to come up with another flim-flam or to survive an election. That is really what is going on in Germany. Any restriction on short-selling is in actuality a way of locking people into the markets and perpetuating false market signals by interfering with the price. Again, that is what is happening in Germany. By banning naked short sales of the euro, protected financial institutions, or credit default swaps, the German government requires a person who (rightly) believes these things are far overvalued by the market to waste money buying options they don’t want (increasing the price of the transaction as a whole) and to create an off-setting buying pressure to negate the effect of the trade on the market. This is all designed to slow the downward movement of the stock or asset price. It is gross interference in the free market in an attempt to manipulate the price of the assets in question. Why Is Government Price Manipulation Bad? So what’s all the fuss? What’s bad about government price manipulation? Just everything.
Consider what the free market is supposed to do. It is supposed to facilitate the flow of investment capital towards the construction of good things. How do you know they’re good? Because people want them enough to pay for them. With the exception of government, people will only pay for things they believe will benefit themselves in some way. And they will only pay as much as they believe the thing is worth in terms of that benefit. So the market, more efficiently than anything else, helps create things people want. The opposite of a free market is a “command” economy, where capital flows to things the government believes are good. Is it possible for any person observing government to believe that a command economy does anything other than favor governmentally connected interests? Even if you believe that government is good and usually tries to take care of people, you must still look at the mechanics of a command economy. If you do, you will see why command economies are so unsatisfying. In a free market, people buy what they want and pay what they have to. They balance their priorities every time they make their purchases. Companies must cater (that’s “pander” to you elitists who think you know better) to the desires of the customers, and over time the competitive process forces businesses to provide more of what people want for less of their money. Some people call this “progress,” but it’s really just the beauty of a competitive free market: you sell your goods by making them more attractive than someone else. In a command economy, by contrast, you don’t have to worry about the satisfaction of the customer. You have to worry about the satisfaction of a governmental official. Even assuming, much against the evidence, that the official is going to be careful and honest, you have still created a centralized intermediary. Fewer people will need to be pleased, and the market will give you fewer signals about what people want. Companies will build things people don’t want. And that is the best case scenario. In reality, government officials can often be “reached” and manipulated. Then you have companies spending large amounts of money to manipulate the bureaucrats through lobbying or bribery or otherwise. That means less money will be available for product innovation and real progress. The ultimate effect of all this isn’t complicated, and it isn’t theoretical. Just look at the Soviet Union and the way it developed and ultimately collapsed. But We’re Talking about Currency Manipulation Here, Not Product Pricing I used product pricing to demonstrate the difference between command economies and free markets. How does that relate to countries stacking the deck in favor of their currencies? It’s really just the same thing on an even larger scale. Consider what is moving the euro right now. Two weeks ago, it took $1.30 to buy a euro, and this week that’s down to $1.23. That shift simply reflects the market’s growing belief that the European Union is about to make some very hard choices, and given their record it’s pretty clear they’ll be making the wrong choices. To put it bluntly, people believe that the E.U. will dissolve and the euro will become useless, or that in its desperate attempt to conserve the union the EU will make decisions which will stifle the European economy’s efficiency and competitiveness.
Considering that the German bank has moved to interfere with the free market, I’d say the market has a pretty good point, wouldn’t you? But in taking such action they may actually be sealing the doom of the euro, so the jury’s out on that question in my book. You can expect a continued decline of the euro, only now it may take longer to “find its value.” Does everybody think the euro will fail? No, of course not. Given a free market, the euro would find its value using supply and demand. That price will reflect that some people think that the euro is circling the drain. They will pay less, and if they are wrong, the people who are right will get more value for their money. Everybody will live and learn–that’s what a free market is all about. The people who are right will, and should, flourish (so they can keep doing right things), while those who are wrong pay for their mistakes and try something else next time. Now that the EU has started down the road to a command economy, they will attract less international capital. Companies with a choice will not send their money where it can get trapped, and people will likewise be loath to invest in an economy where the currency may not reflect its actual value. That’s too risky. People within the economy, not trusting the currency to retain its value, will tend to spend more (on items of certain value) and will save and invest less. They will buy things like gold which have more reliable monetary value. Probably there will be an erosion of trust in government and a commensurate rise in black market activity. And on the grand scale, money will flow to economies which are freer and more dependable. So far, that has included a flight to the dollar and the U.S. economy, but the time is coming when people will see that the dollar is trapped in the same dynamic. This article is ultimately going to be part of “A Regular Guy's Guide to the Economy.” If you like it, please try “A Regular Guy's Guide to Starting an Internet Business” or some of my other materials.