Banning Short Selling in Europe

As anticipated, various EU countries have banned short selling. France, Spain, Italy, and Belgium have thus far thrown their hats in the ring.

Short selling bans are a common interventionary tactic during market declines. The rationale is usually along the line that short sellers are 'unfairly' driving prices 'artificially' lower, perhaps by spreading false rumors or information. This is a subjective judgment, of course. It presumes that bureaucrats can judge the 'correct' price level or the accuracy of information.

In reality, markets are always better evaluators of price and information quality. Good judgments are rewarded and bad judgments are punished.

When short sales are removed from a market, the market actually becomes less liquid during periods of decline. This is because short sellers provide an important source of demand when they buy back securities to cover their position. Absent that layer of demand, markets are likely to fall harder.

We saw precisely this back in Fall 2008 when short selling was selectively banned in US markets. After an initially short covering rally on the announcement of the ban, markets resumed their decline with increased intensity. Less liquidity, deeper elevator shaft.

European markets are seeing similar short covering today. In a vacuum, this is decidedly bearish. Think it thru: What is likely to occur if longs still want to get out of positions and there are no short sellers to buy?

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