New Regs In Germany Show the Downside of Flying Solo

Germany's 'Iron' Chancellor Angela Merkel believes that further regulations on short-selling are required in the EU to alleviate downward pressures on the Euro. The currency has been falling against benchmarks as fears of credit crisis contagion have gripped the continent.

Short-selling is the practice of borrowing securities from a broker and then selling them at today's price in the hope that the price will be lower in the future. This decline would allow the investor to buy the securities at a lower price than they were sold, allowing him to return the borrowed shares to the broker, and profiting on the difference. This is a widely accepted practice in the market, and many investors employ this strategy as a hedge or even as a standalone.

However, some investors 'nakedly' sell securities, or sell them without ever actually borrowing them. This allows for almost unlimited selling and therefore risk. This strategy can lead to large profits, but also carries the risk of huge losses if the security does not decline in price. The lack of actual borrowing before the security is sold can sometimes lead to dramatic swings if a particularly large investor is behind the selling or if a number of different investors are employing the strategy simultaneously.

This naked short-selling and the resulting systemic pressure it leads to is the practice and scenario which Merkel has focused on as she is concerned that speculators will be able to 'gang up' on the Euro via sovereign government debt, selling instruments naked, and creating artificial downward pressure on the currency.  As the nation others often look to for help in an economic or currency crisis (see Greece in the past few months for example) Germany has an interest in ensuring that the Euro remains strong and that the credit crisis does not spread. Political pressures against further intervention have been mounting in the Republic as well.

Merkel is not too far off base in her analysis or conclusions as recent history has seen the result she is seeking to avoid. For example, though it is a bit different than what we are talking about here, George Soros managed to sell the pound down to the point that the England had to withdraw from the European Exchange Rate Mechanism, gaining him the (in?)famous moniker of The Man Who Broke the Bank of England. In that scenario, the short sales were actually backed by borrowed pounds. In the scenario Merkel is hoping to avoid, it is possible that if a large enough speculator (or group of speculators) with a big enough appetite for risk employed the same strategy but sold the securities naked, the impact could be amplified dramatically.

Merkel has already curtailed the practice in Germany, now she wants to do the same in the whole EU. However, it seems unlikely, based on very public comments, that others will follow her lead. Therefore, all she has done is reduce the trading that can be done in Germany without solving the root problem, meaning that German brokers will lose out on profits while the risk to the EU of naked short-selling remains. Talk about a fang 22...

UPDATE: Reuters' BreakingViews has some similar views on this topic as well as some further clarification on the exact instruments that the ban will extend to, including shares in large German financials.