Ban Naked Short-Side Derivatives Now

by: Lawrence J. Kramer
The time has come to ban all naked short-side derivatives. The only way to take a net short position on an asset should be traditional short selling. Everything else creates too much moral hazard.

Moral Hazard 101
“Moral hazard” is a technical-sounding term, but it describes a simple fact of life: people who see less risk take more chances. The effect is universal. For example, studies show that bicyclists who wear helmets have more accidents than those who do not. The injuries are not as severe, on average, but that’s the point: less at risk, more risk taken.

Because moral hazard reflects how real people react to real situations, the only way to determine how much moral hazard a particular risk-reduction device creates is to look at the risks perceived. Insurance types refer to the insured's reason to avoid the risk, even with insurance, as an "Insurable" interest – i.e., an interest that makes the insurance protective rather than speculative, a hedge rather than a wager.
An individual is presumed to have an insurable interest in his or her own life because money cannot compensate for its loss. Nevertheless, insurers do "financial underwriting." Typically, you cannot insure your life for more than your earning power suggests your death would cost your loved ones. Purchasers of health, fire, or auto insurance usually have non-financial reasons for avoiding the relevant risk.
Insurance on someone else’s life is another story. If the someone else is a loved one, we can expect that the owner of the insurance will not do anything to endanger the insured. Again, financial underwriting is applied to breadwinners. Moreover, whenever insurance pays one person if another suffers harm, there are temptations to bad behavior, so state law routinely forbids the purchase of insurance on someone else without that person’s permission.
All states prohibit the issuance of insurance on the life of strangers; the temptation to foul play would be unavoidable and unacceptable. Imagine seeing the following full-page ad in your local paper:

We at Watcherback Insurance Company have recently issued a policy on the life of S.A. Reader, who we found to be in good health except for a severe peanut allergy. It cost us a lot of money to underwrite Reader, and we are hoping to recoup some of the cost by selling contracts on Reader's life to anyone who wants one. If you would like to buy a policy, call your local Watcherback office. The first 100 callers will receive a free bottle of Jif. (Don't worry about us – we're fully reinsured!)

Needless to say, the experience would be unsetting.

Exactly what constitutes an insurable interest is not always clear: whether you are at risk is up to you. If you'd rather have the value of your factory than the business it is doing, then you do not have an insurable interest sufficient to support full insurance on it. But if your business is booming, you do have such an interest.

There are no hard and fast rules, but a few common-sense notions apply. For example, financial guarantee Insurance creates special problems because the risk can always be fully eliminated by insurance. Thus, arrangements that insure financial loss typically provide for some sort of co-insurance: deductibles, co-payments, or both. Those devices assure that the insured is "net long" the asset, thereby reducing the moral hazard in the arrangement.

Short-side Derivatives and Moral Hazard
The problems described above arise from the nature of any given arrangement and have nothing to do with whether that arragement is called "insurance." The deal are bad because they are bets, and not just any bets (I'm not here about the evils of gambling), but bets that can be rigged. Suppose you're the CEO of a publicly traded company, and you saw this ad:

We at Watcherback Investment Bank have recently issued a Credit Default Swap on the bonds of Reader, S.A., which we found to be in sound financial condition except for its vulnerability to naked short selling. It cost us a lot of money to underwrite Reader, and we are hoping to recoup some of the cost by selling a CDS on its credit to anyone who wants one. If you would like to buy a Reader CDS, call your local Watcherback office. The first 100 callers will receive a free brokerage account at our bucket shop. (Don't worry about us – we've already got counterparties for the contracts.)
Needless to say, the experience would be unsetting. (Yes, there's an echo in here.) As might be imagined, sharp operators took advantage of these contracts, buying CDS contracts on vulnerable companies whose debt they did not hold, then using various strategies, including so-called naked short selling, to bring those companies down to collect on the CDS contracts.

Any short-side bet that can be scaled to the point that it pays to mount a naked short attack on the underlying security poses an unacceptable risk to the markets. Naked shorting itself is such a bet. Even without a CDS, a manipulator can use naked shorts to panic the market and then buy back in at stampede prices. In the meantime, holders of the underlying security become subject to margin calls, and all sorts of systemic chaos is unleashed, while no legitimate market-making purpose is served.

Regulators should have seen this coming. Naked short-side derivatives violate every relevant principle of insurance underwriting and public policy. Why, then, are they legal? I can only guess that insurance people were not asked to think about them, or, if they were asked, that their answers were ignored. Insurance is such an arcane thing and all. Instead, in what can most charitably be called an act of boneheaded stupidity, Congress tried in the Commodities Futures Modernization Act of 2000 to put CDS contracts outside the reach of state insurance, gambling, and bucket shop laws.
Perhaps because financial services lawyers rather than insurance and tort lawyers have been consulted about the matter, the purported Federal preemption of state laws appears to be getting more respect than it deserves. Eventually, some clever tort lawyer will figure out how to get past the CFMA’s preemption language, and the proceeds of naked CDS contracts will go to the creditors whose loans their CDS contracts caused to go bad. Then they can go to work on the damage inflicted by naked short sellers.

End it, Don’t' Mend it

Be that as it may, I think all net-short derivatives should simply be banned, by legislation or, to the extent possible, by regulation or exchange rules. And don’t get me started on "transparency" – some kind of exchange or clearing house for derivatives. The problem is not price discovery. The things ought to be illegal. How on earth can selling them on an exchange make them any less dangerous?
I am not proposing that all short-selling, or even all derivatives, be banned. Traditional short-selling of borrowed shares (not shares that have to be borrowed by next Thursday, but shares that have already been borrowed) is an important source of balance and liquidity in the markets, where tax and psychological reasons not to sell may have nothing to do with the value of shares. Puts on owned shares are also useful hedges, as are covered calls. (Naked calls may be too small to support an attack on shares, but they don't seem to me to serve any purpose, either.) What the "good," net-long derivatives have in common is that they are, in a sense, "backed" by real shares. Think of what I'm proposing as a sort of "share standard" analogous to the gold standard for issuing money.

Many of these derivatives were created to deal with the volume and risk profile of foreign investors looking to repatriate trade deficit dollars. Ever dollar that can be put to work in the casino is a dollar that does not have to be put to work somewhere else. The dollars themselves were put into Treasury bonds used to collateralize the bets, so, from a macro standpoint, derivatives created another route for foreign dollars to get to the Treasury. What I think that means is that if these securities are banned, the money will go to the same place, only at a lower promised return. But, as the kids say, whatever. Naked net short positions, however accomplished, serve no useful purpose and should be outlawed.

No stocks named.

Disclosure: No stocks named.