The Spanish regulator has admitted that the short selling ban had a detrimental effect on the markets.
The ban was introduced as part of recommendations from the European Securities and Markets Authority (ESMA) in August last year. ESMA published a paper in favor of the ban in the Eurozone, upon which Belgium, Spain, Italy and France decided to ban the activity on all financial instruments in order to stem market volatility, accrued by the instability of the Eurozone. Then, in Mid-February, most of those countries, including France and Belgium but excluding Greece, lifted their bans on short selling. In all cases, while the regulators have lifted outright bans, disclosure requirements and various restrictions on naked short selling remain in place.
In its latest report on the state of Spain’s financial markets, the Spanish regulator CMNV acknowledged that as a result of the instability, many financial firms suffered downgrades and in this context short selling was introduced to preserve market stability and guarantee its normal functioning. The fall of macroeconomic indicators and contagion risk in different markets and sectors further necessitated the need for the ban.
However, while the ban is justified by the fact that aggregated risk and market volatility affect present and future income expectations from investments, CNMV notes a worsening in public debt may affect financial institutions holding that debt. In addition, government liquidity measures affected banks’ rating. Similarly, lower macroeconomic expectations affect the markets and the banking rating as a consequence. In this contest, an increase in short selling can cause major instability.
The CNMV report says the ban measure is based on deteriorating economic conditions, market volatility and falling European stock exchanges. These conditions, it says, are to be blamed on the management of state public finances accompanied by the lack of political agreement on the public debt in the US. This led to a fall in the US treasury bond grades on August 5 2011. Spain suffered particularly due to a lack of EU measures to deal with the Greek crisis, noted the CNMV. The Greek crisis had repercussions on the other economies of previously stable countries such as Belgium, Italy, France and Spain, with the fear of systemic risk growing too, it added.
The link between the public and private sectors means that tensions were transferred to firms as well, particularly for the banking sector, notes the CNMV. Many US money funds contracted their exposure to the ECB (a 27% drop) and the EU risk rating increased with the worsening of the Greek situation.
The CNMV report says stock prices are not linked to firms fundamentals: if short selling is applied because of a perception of worsening fundamentals of a firm, banning the activity artificially increases the net demand of securities, increasing their prices, which is incompatible with the financial stability, even if stock pricing is not linked to the actual value of the firm. In case of multiple equilibriums, stock prices are also affected by other reasons than the fundamentals and additional liquidity can avoid stock price drops. CNMV also notes a correlation between stock prices and firms financial stability: in the first case, a drop in stock prices may affect a firms financial stability. Therefore, banning short selling may be ineffective in this case. Nevertheless, there are no infallible and instant ways to assess the impact of short selling, according the CNMV.
– Janet Du Chenne and Ilaria Guandalini (Strategic Insight www.sionline.com – an Asset International company)