Europe Short Selling Ban Ineffective

by: James A. Kostohryz

There is a sense in which the short selling ban announced by France, Spain, Belgium and Italy sends an important signal. It puts investors on notice that governments have ways to make short-side speculators pay for overly aggressive bearish bets in financial markets.

Having said that, the short selling ban that has been announced -- mainly directed at protecting financial stocks and bonds of banks such as BNP Paribas (BNQPY.PK), Societe Generale (OTCPK:SCGLF) and Credit Agricole (OTCPK:CRARF), Santander (STD) and BBVA (NYSE:BBVA) -- is largely ineffective from a functional point of view. Five reasons:

1. Dissension. European leaders have not been able to achieve consensus on this issue, with the British loudly dissenting. The lack of consensus gives an impression of disunity and disarray amongst regulators.

2. Ban not global. Many French, Spanish, Italian and Belgian bank stocks, bonds, and other securities trade in various bourses in Europe and the U.S. where there is no short sale ban. In many cases, investors that cannot execute short stocks in France, Spain Belgium and Italy can do in London, Frankfurt, the U.S. or other countries.

3. Rules do not ban sales. Short sales may be banned, but sales are not banned. In the end, what matters is investors' perception of the fundamentals. If current holders of bank stocks believe the banks to be fundamentally overvalued given their perception of current and future fundamentals, they will sell. Similarly, if short sellers pushed prices down below the level that investors considered fair value, demand for the stocks would emerge which would support the stocks. The bottom line is that although banning short sales might prevent some degree of short-term volatility, in the medium term they will not affect the valuations at which the banks trade.

4. Work-arounds. Derivative contracts such as swaps can be structured in such a way as to achieve the same result as short sales. Investment banks are expert at this, and such transactions are perfectly legal.

5. History. Investors will not give great credence to intended benefits of the ban due to the fact that historical experience with such bans has been that they are ineffective. In particular, recent attempts to impose restrictions on short sales in order to support bank stocks in 2008 ultimately failed. Initially, bank stocks rallied after the temporary ban was announced. However, within weeks, bank stocks were down by 30% or more and did not bottom out until about 6 months later.

In sum, the short sale ban announced in Europe is a reminder that governments are able and even eager to punish bearish short sellers. Various mechanisms are available. However, the short sale ban announced on Thursday is unlikely to have any lasting effects unless it were accompanied by a whole package of decisive and coordinated actions by central bank and regulatory officials around the word.

Such pan-European and transatlantic coordinated and decisive action will be extremely difficult to achieve. Furthermore, such measures are unlikely to be adopted before stock prices and indices such as the ^FCHI, ^MIBTEL, ^SMSI, ^GDAX, ^FTSE and ^SPX are substantially below current levels.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.