France, Spain, Belgium and Italy have announced short-selling restrictions on certain derivatives and financial stocks. The French, Italian and Spanish restrictions ban short selling on a range of stocks for 15 days, while the Belgian ban will cover four stocks for an indefinite period.

These bans followed abrupt drops in financial shares the week of the 8^th of August 2011, and it has sparked a debate between European regulators with Britain, the Netherlands and Austria refusing to introduce similar restrictionsand Germany pushing for a Europe-wide ban on naked shorting.

Explaining short selling

Short selling involves opening a position on a financial product by selling the product and then buying it back at a lower price, profiting on the difference between the opening and closing prices.

While going long (buying in the hope that a price will rise) allows traders to profit in rising markets, short selling enables a trader to make potential profits in falling markets as well. Often difficult to do when trading traditional shares, this is one of the often-touted advantages of derivative instruments like CFDs, which often make it just as easy to go short as to go long.

Why the restrictions?

European banking stocks have recently been moving on rumours about the funding needs and healthof eurozone debt. The DJ Stoxx index of European banking stocks fell 17% in the first two weeks of August, and fell 37% from its February peak.

Having hit a 28-month low on Thursday August 11, the European Securities and Markets Authority (EMSA) has said that shorting combined with rumour mongering can lead to market manipulation.

When has this happened before?

Following the collapse of Lehman Brothers in 2008, the SEC (US Securities and Exchange Commission) banned going short in a number of banks and financial institutions for three weeks. Although this resulted in lower share borrowing, financial shares continued to plummet, which raised questions about whether regulators should interfere in free markets.

Even before the financial crisis financial stocks resulted in regulator concern. In 1938 the SEC implemented the uptick rule, which stated that before a trader could go short on a share it must trade higher at least once. The uptick rule was intended to prevent investors contributing to falling share prices after the Great Depression.

Do bans on shorting work?

London analysts, traders and academics have questioned the value of shorting bans, arguing that they damage the market by disrupting the natural market functions and lowering liquidity by shutting out some participants. Such restrictions also don’t address the causes of trader concerns; in this case, the eurozone debt crisis.

In the global financial crisis, Christopher Cox, the former SEC chairman, said that the 2008 three-week short-selling ban was his greatest mistake as chairman. A Credit Suisse study found that the prices the shares of 799 banks and other financial institutions restricted from short selling still fell by 21.8% in the crisis, while the broader market only fell by one percent more at 22.8%.

Returning to the 1938 uptick rule, in 1963 the SEC established three objectives to assess whether it continued to be effective:

1. It should allow relatively unrestricted shorting in an advancing market
2. It should prevent shorting at successively lower prices, eliminating shorting as a way to drivetool for pushing the market down
3. It should prevent short sellers from accelerating a falling market

With these objectives in mind, the SEC established a pilot program in 2004 to determine whether the uptick rule was still effective. Although the elimination of the uptick rule increased the volume of shares that traders short-sold, the program found that it did not increase the percentage of stocks that were short sold.

Following these results, the rule was eliminated in July 2007, though there were calls to reinstate it later that year and throughout the 2008-2009 financial crisis. Those supporting the uptick rule have argued that the conditions of the 2004-2006 pilot program were different to those of the 2008-2009 market crash, and have said that reinstating the rule will protect the stock of struggling companies, which have been driven down past their fundamental value by shorting.

In defence of short selling

As seen from the use of the uptick rule and the US ban on going short in 2008, restricting shorting does not have a large impact in supporting falling markets.

Although short selling has gotten a lot of bad press, it is not shady or unlawful. It is a trading technique that gives a trader the opportunity to profit in any market, and is also a necessary tool for correcting asset prices that have been pushed to highs that aren’t supported by fundamentals.

Trading CFDs is one way in which traders can take advantage of falling markets by shorting. Short selling is sometimes difficult when trading conventional shares, and investors may be charged an extra fee for the privilege, but with CFDs it is just as easy for traders to short (sell) as it is for them to go long (buy), and they are able to trade a range of global markets all from one, browser-based trading platform.

Remember that CFDs and forex are leveraged products and can lead to losses that exceed your initial deposit. CFD trading may not be suitable for everyone, so please make sure you understand completely the risks concerned.