Assessing the arguments against shorting

Some politicians and regulators in Europe have suggested restrictions on the short selling of government bonds and credit default swaps referenced to those securities. Hans Blommestein, Ahmet Keskinler and Carrick Lucas at the OECD argue such a move could be detrimental for liquidity

Regulators across the globe are working to implement new regulations designed to improve the stability of financial markets. As part of this, some supervisors and politicians have proposed banning the naked short selling of government bonds and derivatives related to those instruments. If adopted, this would mean that prospective sellers (possibly including market-makers in sovereign debt) would first need to locate and reserve the securities in question. 

Sovereign issuers and primary dealers have expressed their unease about the potentially adverse impact this would have on government bond markets. They argue any restrictions would need to be supported by concrete evidence that proves unrestricted short-selling activities are linked to fraud, abuse or market manipulation (OECD, 2011). To date, however, such hard empirical evidence is lacking.

Instead, all signs point to the fact that short selling benefits market liquidity and pricing efficiency, and enables more effective risk management. Reducing access to short selling for risk management purposes will make markets less stable, and is likely to lead to higher borrowing costs for sovereigns. 

This article assesses the potential adverse consequences of short-selling restrictions, both in terms of risk management and government borrowing costs.

Benefits of shorting
Short selling provides some important benefits, including support for market liquidity and risk management. Moreover, it can foster investor confidence, as market participants can be sure that prices reflect both optimistic and contrarian views or sentiments. Short selling also enhances the efficiency of the price formation process by ensuring markets reflect underlying fundamentals.

A prohibition on uncovered short selling has the potential to exert an adverse influence on the functioning of markets, and in particular on liquidity. The diversity and depth of liquidity would fall if investors were to start withdrawing from sovereign debt markets in the face of actual or potential restrictions (including public disclosure of short positions).

Limitations would also increase the costs of risk management by hampering investors and primary dealers in their ability to hedge in both primary and secondary markets. Short selling is crucial for the better functioning of both primary markets (such as auctions) and secondary markets (such as trading and market-making in sovereign bonds) by providing an important tool to hedge the risk of a long position in the same fixed-income instrument or related security.

Risk management
Concerns have been raised about the impact of a short-selling ban on risk management practices, since routine hedging operations would become impossible or much less straightforward to execute. Clearly, this would have a negative impact on sovereign debt markets, as it would reduce the ability to short bonds for risk management purposes. Similarly, it might deter investors from taking a position on the basis of an interest rate view. Eliminating such investors from these markets would be harmful to liquidity, and would lead to a rise in the liquidity risk premium and an increase in sovereign borrowing costs.

Covered versus uncovered short selling
Covered short selling involves an investor borrowing the bond and then selling it immediately. Naked shorting means the investor sells the security without owning or borrowing it. The motivation for short selling might be to hedge in anticipation of heightened market uncertainty (be it political, economic or other market-related risk), to express an outright view on the future direction of interest rates, or ahead of an expected cashflow.

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Assessing the arguments against shorting