I already wrote about how short selling bans fuel market rises in the short-term, but today I will focus on how these bans fuel market crises.
Short sale bans of some stripe exist in Spain, Greece and Italy. The Spanish and Greek bans are total and all encompassing with their respective regulators prohibiting any and all short sales. The Italian ban only applies to naked short selling, which means that a prospective short seller must borrow the shares and pledge them for delivery in case of a sell-out of his position.
The issue with barring speculators from transacting short sales is that the market becomes one-sided in favor of buyers. A one-sided market is an inefficient market.
Buyers borrow money to purchase stocks, while short-seller borrow shares to sell stocks. All of the central bank action since the onset of the GFC has made gobs of cheap money available to prospective bulls fueling the ongoing bull market.
This action has also caused the number of bears willing to bet against securities decrease because they fear that central banks will continue to manipulate stock markets upwards as long as they can, a de facto short sale ban.
Bears are further reduced by de jure short-selling bans. The bear plays two useful roles in financial markets. First, he sells short keeping the exuberance of a rising market in check.
This is beneficial, because bull markets are not optimal for everyone. Those who own large portfolios of stocks benefit from rising markets, but those who need to purchase large amounts of stocks (e.g. young people saving for retirement) are hurt by high prices.
The bear’s second role may be even more important. Remember that every short position will eventually be closed. Short sellers must buy back the shares that they have sold short to become flat.
When the market drops, the short seller purchases shares to take profits on their existing positions reducing the severity of a sell-off. If you’ve ever wondered who the hell is buying stocks during a market meltdown, now you know.
One of the major problems with short selling bans, whether de jure through regulatory prohibition or de facto through central bank action, is that when a sell-off inevitably materializes there is no one to buy to temper selling pressure. Without short-sellers, a sell-off can turn into a correction and a correction can become a panic.
The next time an adverse event takes place in Europe, watch the stock markets of Greece, Spain and Italy. As long as the short-sale bans are in effect, these will be the most fragile, but do not discount the fragility of other stock markets. Cheap central bank money has increased their fragility, which will increase the severity of their next corrections, too.