How will demonization affect the stock market?

Short selling as the scapegoat of the financial crisis

In the wake of the financial crisis, regulators in various countries banned the short selling of stocks. The hope behind the ban is to break the downward spiral in share prices - especially in financials. For many economists, however, short selling is part of a functioning stock market because, contrary to the assumption of many politicians, it tends to reduce rather than increase volatility in the market. (Red.)

The turbulence on the financial markets of the last few months and probably also the urging of the company leaders of listed financial institutions, whose share prices have come under pressure, have induced the stock exchange supervisory authorities of practically all important financial centers to impose in some cases drastic restrictions on short selling. A short seller is an investor who sells securities that he does not even own. Put simply, the short seller speculates on falling stock exchange prices, so he makes a profit if the prices fall as anticipated. So that he can meet his delivery obligations, he usually borrows the titles. When the loan transaction is due, he will buy back shares on the market and thus "close" the loan transaction. If the share price is lower at the time of the cover purchase, the short seller has made a profit after deducting the transaction costs. Put simply, the price loss represents the short seller's profit.

Short selling in many investment strategies

Short sales are used in very different investment strategies: One example is the so-called "Convertible Bond Arbitrage", where investors try to generate a profit from inconsistencies between the market price of the convertible bond and that of the underlying shares: Are the shares closed compared to the convertible bond? expensive, the investor buys the convertible bonds and sells the stocks short. In economic terms, the sale is covered by the purchase; In fact, the seller does not always have a full claim to delivery of the securities because of financial or legal details. Similar strategies are also used by investors who anticipate positive price developments for certain stocks but are skeptical about their industrial sector. In such a stock market assessment, the preferred stocks are to be bought and all others in the same industry to be sold short. With this strategy, the investor is only exposed to the relative difference in value (comparison of shares versus industry). It is hardly disputed among economists that bearish speculation is part of a functioning market. It is basically just the opposite of the generally understandable long strategy, in which securities are bought in the expectation that they can be sold again at a later point in time at a higher price. Short sellers dampen price exaggerations or the formation of bubbles and thus help to create a price-efficient capital market.

Short sellers in disrepute

As the "treasury of the financial markets", however, short sellers have been pilloried in the past as well as today as the cause of financial crises: As early as 1609, short sales on the titles of the Dutch East India Company were prohibited, and since then short sellers have often been demonized: even in the last In the James Bond film, the villain “Le Chiffre” was a short seller.

Why did the short sellers suddenly get on the radar screen of the supervisory authorities again, even though financial market theoretical studies do not support a negative assessment? The trigger was probably the pressure that weighed on the stock market valuation of listed financial institutions and pushed prices down substantially. This collapse in prices caused the refinancing costs of the banks to rise sharply, which seriously threatened the financial institutions. Since the failure of larger financial institutions can trigger a systemic crisis due to their extensive networking in the financial system, state actors were forced to intervene. In the hope that a ban on short sales, some of which is temporary, will be able to stop price losses and thus ultimately not need state safety nets, the financial supervisory authorities around the world have issued such bans in a flood - each based on very vague legal bases, without consultation or other democratic instruments of participation and with a fleeting legal preparation, which often had to be supplemented afterwards. However, the numerous government aid packages for banks suggest that the instrument is not very handy. This conclusion also emerges from empirical studies that show that the poor performance of certain financial stocks cannot be attributed to short selling.

Covered and uncovered

The bans on short selling have varied depending on the market and country. Certain supervisory authorities have taken offense at the market behavior of so-called “naked short sellers” who, at the time of the conclusion of the sales transaction, did not ensure that they could deliver on the settlement day. The US Securities and Exchange Commission has been publishing data since December 2007 that provides information about how often the seller failed to deliver the securities on the settlement day. In the meantime, American regulators have issued stricter bans.

In Switzerland, the Swiss Federal Banking Commission (SFBC) and the SIX Swiss Exchange have stated that uncovered short sales are incompatible with the market behavior rules applicable to banks and securities dealers. In the opinion of the supervisory authorities, there is an uncovered short sale if, when the transaction is concluded, it is not certain that the securities can be delivered on completion on the settlement day. In order to meet these requirements, it is sufficient if the seller has the title z. B. in the context of a securities lending (loan of securities). However, he does not have to be the effective beneficial owner of the securities. In other countries, the financial authorities have taken even more drastic measures: In the UK, the Financial Services Authority has issued a general ban on net short positions on certain financial stocks. This prohibits not only uncovered short sales, but also covered short sales and economic short positions (e.g. through the use of derivatives). The UK authorities - like most other authorities - only wanted to protect their national institutions and have limited their ban to UK financial institutions. At the request of the SFBC, SWX Europe closed this “loophole” for SMI financial stocks such as UBS, Credit Suisse and Swiss Re traded in London: Short positions in these financial stocks are now prohibited and disclosure rules also apply.

Anyone who lends securities bears risks

Ordinary investors are hardly directly affected by this ban: on the one hand, because the SWX Europe regulation only covers their members, and on the other hand, because small investors are rarely able to sell stocks short. Only those investors who have invested in hedge funds are affected, as the restrictions limit their investment strategy. This can of course have a negative effect on the expected return, depending on the strategy of the respective hedge fund. Private investors are more likely to come into contact with short sellers through the securities lending business. In order to fulfill their duties, short sellers must borrow the stocks. Banks often act as intermediaries in this business and often ask their customers to authorize them to borrow securities from their customers' custody accounts for an interest rate. This business opportunity is more likely to be used by passive - private or institutional - investors who can generate additional income on their portfolios.

The authorization to lend has far-reaching consequences for customers. In such transactions in Switzerland - and abroad - the customer does not have a right to segregation in the event of the bankruptcy of the counterparty and thus bears the full counterparty risk. In practice, the bank will often act as the customer's counterparty. In such a case, the customer has no right of separation in the bankruptcy of the bank. Conversely, in this constellation, the customer does not bear the risk that the final borrower will not be able to return the title in accordance with the contract. This risk is borne by the bank, which acts as an intermediary between the customer and the borrower. Other legal constructs are often used for institutional investors such as pension funds. In such a constellation, the bank does not act as a counterparty, but merely as an agent or broker. Then the (institutional) customer bears the default risk of the borrower. This risk is hardly affected by the ban on uncovered short sales. The SFBC decided a few years ago that the authorization for securities lending should not be “packed” into the general terms and conditions, but rather require separate approval from the customer. In doing so, the SFBC wanted to ensure that customers are aware of the risks involved in lending securities.

The hoped-for effect failed

The question arises as to whether these somewhat hasty reactions by the supervisory authorities will not result in any unintended negative consequences. In particular, the prohibition or hindering of short sales could have a negative impact on the liquidity of the financial markets. In addition, such surprising interventions call into question the predictability of the regulation. It has amazed some market participants that the most varied of regulators could be induced to intervene practically at the same time. However, it gives the impression that the measures did not bring the hoped-for results, if one takes the price decline of the last few weeks for financial stocks as a yardstick. Perhaps the measures were necessary to demonstrate to political authorities and the population that the supervisory authorities are able to act quickly. It is interesting, however, that financial institutions were also given protection against short sales who had previously made good money for years as prime brokers of hedge funds with the trading activities of these funds and their short sale strategies.