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 spiral.
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 prohibited.
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 fallout.
And here's why a collapse in German banking is a nightmare scenario for the country: Deutsche Bank ( DB ) alone has assets valued at 84% of the entire German GDP . Compare that to the situation in the U.S., where JP Morgan Chase ( JPM ), Bank of America ( BAC ), Citigroup ( C ), Wells Fargo ( WFC ) and Fannie Mae ( FNM ) combined 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 the hills
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.