Short selling is a surefire way to make money during bear
markets. In most cases it's perfectly legal, but there are laws in
the U.S. prohibiting what is known as "naked short selling."
And now, Germany has unilaterally imposed a ban of its own. On
May 18th, Germany shocked the markets by announcing a prohibition
on naked short selling of certain European bonds and shares of 10
leading German banks.
How Naked Shorting Works
Naked shorting is shorting a stock without borrowing shares
first. Traders take advantage of the three-day settlement window to
sell a stock and buy it back at a lower price without having to
actually possess the stock they sold and bought.
Let's say XYZ Inc. has 10 million shares available for public
trading. Data shows that institutions own about 8 million of the
shares and the rest are owned by retail investors and traded on
exchanges. A traditional short seller could short 50,000 XYZ shares
by borrowing 50,000 shares from someone willing to lend them.
With naked shorting, the object is to quickly punish a particular
stock. A trader taking a naked short position could
conceivably short 3 million shares even though there are only 2
million available, since he doesn't have to borrow the shares to
short them. People see a rising short interest and a falling share
price, so they head for the exits. This additional selling drives
down XYZ down even more, potentially becoming a downward price
Though illegal in the U.S., naked short selling is largely legal in
other countries, so getting around bans is fairly easy as long as
you're doing your trading in a country where naked shorting isn't
Why Does Germany Want to Ban Naked Shorting Now?
Some market participants and many politicians believe that naked
shorting can manipulate markets and falsely drive prices lower.
The Greek debt crisis has exposed German banks as being
especially vulnerable, making them a juicy target for short sellers
of all kinds. Germany has taken a cue from the U.S. in how to deal
with these modern-day versions of bank runs. In 2008, the SEC
banned traditional short selling of certain banks in an attempt to
keep their stock prices from going to zero.
An additional explanation is that that the German government could
know that even more bad news is going to come out of European
financial markets, so they're trying to buffer their banks from the
And here's why a collapse in German banking is a nightmare
scenario for the country: Deutsche Bank (
) alone has assets valued at 84% of the entire German GDP . Compare
that to the situation in the U.S., where JP Morgan Chase (
), Bank of America (
), Citigroup (
), Wells Fargo (
) and Fannie Mae (
have assets of only 56% of U.S. GDP.
One thing is certain…a ban on naked short selling is not a ban
on traditional selling, so there's only so much government
intervention can accomplish if investors get spooked and run for