Market chaos predicted as Germany bans shorting

Tuesday, May 18, 2010
By Paul Martin

Traders are predicting chaos on the world’s second-largest government bond market after the German authorities on Tuesday announced a ban on all naked short-selling in European public debt, as well as shares in the country’s 10 largest financial institutions.

By Harry Wilson
18 May 2010

The unprecedented step saw the euro sink to a four-year low after Germany said that from midnight shorting of credit default swaps of any European government would be banned. The prohibition is an attempt to counter speculators that Berlin believes are trying to destabilise the region’s sovereign bond market.

Traders greeted the move by BaFin, the German regulator, with a mixture of anger and astonishment. One bond trader said he expected Wednesday’s trading session to be one of the most volatile in living memory: “It will be complete chaos, I really don’t know what the Germans think they are doing.”

One immediate effect was that the cost of insuring European government debt fell as markets were hit by a so-called “short squeeze” where investors with short positions are forced to offload their holdings and buy the bonds, causing the price to increase.

This is certain to please the German authorities, who have waged an increasingly hostile war of words with supposed speculators.

BaFin said the ban was being introduced due to “extraordinary volatility in debt securities issued by eurozone countries”.

In a statement, it said short-selling had led to excessive price movements “which could have led to significant disadvantages for financial markets and have threatened the stability of the entire financial system”. However, traders said that the measures, which will also prohibit the naked short-selling of shares in major German financial institutions, such as Allianz. Commerzbank, and Deutsche Bank, could lead to an immediate backlash from investors around the world.

They added that the ban was likely to be effectively unenforceable. It will not stop traders from shorting the bonds and shares using other European markets.

“Without the two-way flow the German market is likely to become utterly dysfunctional,” said one London-based bond trader. “Nobody ever thought they’d do this in a million years and it raises the long-term question of who is now going to want to buy their debt.”

Germany, like other European governments, must raise hundreds of billions of euros by selling new bonds, but banning short-selling could jeopardise demand.

Analysts at Bank of America Merrill Lynch summed up the mood with a note titled What’s Germany going to ban next? Rainy days, harsh words, the Macarena?

US shares fell as traders began to assess the consequences. After an early rally, the Dow Jones closed down more than 100 points, despite a day of gains for European markets.

The German authority’s actions echo those taken by many major Western governments in the wake of the financial crisis in late 2008 following the collapse of US investment bank Lehman Brothers. Britain and the US both temporarily banned shorting bank shares, fearing that speculators could cause the collapse of other major financial institutions.

Speaking to Reuters, Lawrence Glazer, managing partner of Boston-based Mayflower Advisors, said: “The motive is probably more towards limiting volatility and trying to prevent some sort of raid on debt, or equities. We have seen this before, but whenever you see any type of regulatory changes it is worth paying attention.”

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