Aktuelles Stichwort: "Leerverkauf" Interview with Hans-Werner Sinn (in German) 18.10.2010 Media Library of the CESifo Group
The term “short-selling” is used in banking and finance. It refers to the sale of goods, securities or foreign exchange that the seller does not posses when they are sold.
By selling short an investor bets that the price of the object sold will fall. While relatively high profits can be achieved by short selling, high losses are also possible. Short-selling thus numbers among the speculative financial instruments.
In short-selling the purchaser is obligated to supply the investment object within the usual delivery period of two to three days (spot transactions) or at an agreed later point in time (forward transactions, futures). To be able to fulfil this obligation, the purchaser usually borrows the investment object at a specified fee. If securities are involved, this is called a security loan or a repurchase agreement. At the time of delivery, the purchaser delivers the borrowed security to the customer at the agreed price. Shortly before the expiration of the borrowing period, he must purchase the same security on the market in order to return it to the lender. If the price has fallen in the meantime, the seller achieves a profit amounting to the decline in the price minus the rental fee. If contrary to expectations the price has increased, the seller will make a loss.
With a naked short sale the seller does not back up the transaction with a borrowed security and at the point in time of the sale he also possesses no legal claim to a borrowed security. In order to fulfil his obligation, he must thus acquire the asset before the agreed delivery date. If he can buy it more cheaply than he sold it, he makes a profit.
In addition to pure speculation short-selling is also used to hedge risks from other transactions. For example, short-selling a security protects against losses from the forward purchasing of the same paper.
Short-selling is subject to a special market price risk. The relationship between chances and risks are the exact opposite as that for the purchase of stocks. With stocks the maximum loss is limited to the purchase price since the stock price cannot fall below zero. The gains from a rise in the stock price, on the other hand, are theoretically unlimited.
For short-selling the opposite is the case. The seller’s maximum theoretical profit is the selling price if the price of the stock has fallen to zero at the time of the repurchase. Conversely, the losses that can arise if the stock price shoots up are theoretically unlimited.
Since short-selling has not been legally defined in Germany, the general law of sales applies, which entails that short-selling in Germany is basically permitted. Since 2003, however, some investment trusts have been forbidden to carry out these kinds of transactions.
As a result of the financial crisis, regulations on short-selling have been tightened several times since 2007. At first, Germany’s Federal Financial Supervisory Authority (BaFin) temporarily prohibited the naked short-selling of eleven financial titles. This prohibition was lifted in January 2010. Since March 2010 short-selling above a specific magnitude must be reported to BaFin and/or made public. On 2 July 2010, the law on the “Prevention of Abuses in Transactions with Securities and Derivatives” (17/1952) took effect that bans the naked short-selling of stocks and government bonds of eurozone states.
Selling short is speculating on a fall in prices. Such speculation is not problematic in itself. Anyone who sells for future delivery is also speculating on declining stock prices. He obliges himself today to sell the security at a previously determined future date at a specific price, and when this point in time arrives he buys the security on the stock exchange. Profits will accrue to the seller only if the future stock price falls below the pre-agreed futures price.
Short selling and futures transactions differ, however, in one important point. Futures have a stabilising effect on stock prices while short-selling have a destabilising effect. The forward seller drives a declining price back up when he buys the security on the stock exchange before its delivery. The more speculators engaged in futures transactions, the more stable the stock market.
With short sellers it is different. They too drive the future stock market price up when investors repurchase the papers; but first the prices have been pushed down by the sale of the borrowed papers. This leads to a downward and upward movement of prices that would not have occurred in the absence of short-selling.
From the viewpoint of the individual speculator, short-selling only has an advantage over futures speculation if he can borrow a sufficient number of securities to be able by himself to depress the price of the securities. This is what economists call market power. When the speculator uses his market power to cause a decline in prices, he creates by himself the conditions for a favourable repurchase of the securities. This manipulation of the market is damaging from an economic viewpoint. Private profits that result from monopolistic market power are an indicator of economic inefficiency and general welfare losses. Since from an economic viewpoint short-selling does not offer any further advantages over futures transactions, it should in general be banned.
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