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CDS prices fall after short-selling bans

On the face of it, the August 11 ban by four eurozone countries of the short selling of a variety of financial stocks has done the trick. The five-year credit default swap (CDS) price of Societe Generale – the precipitous sell-off that prompted European regulators to act – has recovered sharply since the ban was imposed.

It closed at 328 basis points on August 11 and was 30bps narrower by the close on the following day. By the start of the following week it was back to 280bps and on August 17 it closed at 258bps – 70bps inside prices six days earlier.

The other two major French banks that had been caught up in the SG panic, Crédit Agricole and BNP Paribas, also rallied hard. Italian banks like Unicredit and Intesa Sanpaolo, which had peaked at 386bps and 332bps in the CDS market respectively, narrowed substantially as well. Belgium, France, Italy and Spain imposed the ban, but before the regulators start patting themselves on the back for having saved the European economy (again), there are several other factors to be considered. Firstly, it seems that there was no real substance to the rumours circulating about SG the week before last. They were vigorously denied by the bank itself, and on August 12 traders were very reluctant to pass on what they had heard, even on an entirely unattributable basis. One credit analyst last week said: “There wasn’t anything in the rumour. So whether you congratulate the short-selling ban or if the rally is due to the fact that the rumour was baseless is a moot point.” Moreover, the ECB has taken steps to buy up substantial quantities of French and Italian assets. The scale of this buying was hailed as a “positive surprise” by one dealer and also helped the market. Finally, the market was much calmer last week than it had been the previous week. The iTraxx Main Europe Index, which had bolted over 150bps to a high close of 156bps on August 11, retreated to 141bps by the middle of the last week. The Crossover index also narrowed.

There had been no more negative news, and a more generally relaxed and typical holiday mood had entered the market. The short-selling ban certainly showed that the regulators meant business, but it would be wrong to attribute last week’s rally solely to their actions. It is, however, somewhat worrying, though perhaps not a surprise, to find European regulators once again so keen to shoot the messenger. Banning short selling of financial stocks does not make institutions any more solvent or commercially viable.

Neither is it certain that short selling caused the sudden decline in the stock price of French banks 10 days ago. It seems more likely that it was selling by investors who already owned the stock. The ban will do nothing to prevent this type of selling.

But it is the stunning ineffectiveness of this sort of ban that is perhaps most striking. The US tried it in 2008 following the collapse of Lehman Brothers and prohibited the short selling of 880 different financial stocks. In the short term, markets rallied, but within three weeks the price surge had evaporated. The price of stocks covered by the ban had fallen by a mean of 25% while the S&P 500 had also dropped by 21%. Hardly a propitious augur. The banning of short selling does not prevent investors taking a short position, either. A great many, perhaps the majority, of short positions are accomplished by proxy rather than outright exposure. An investor could, for example, sell a CAC-40 future, buy stocks except the banks and be short the French banks. Or the investor could simply take positions in banks unaffected by the ban, which would be sure to collapse in price even if the market rumours concern rival institutions – as occurred during the SG meltdown.

Investors could also make a short trip across the Atlantic to New York and sell ADRs (American Depositary Receipts) in the respective stocks if they really wanted to short sell French banks. The ban is also inconsistent. France and Belgium, for example, continue to allow the trading of certain equity derivatives, while Spain has extended the ban to include derivatives. The upshot in the short term may be simply to diminish liquidity in these stocks and widen bid/offer spreads. Like the proposed financial transactions tax, it means less business and lower returns for the banks that make large amounts of money in these markets. This is not good news for European banks with large investment banking divisions – SG, for example. In the midst of all this, Germany added a characteristic wrinkle by proposing to ban not all short selling but all naked short selling across the EU. Germany, of course, banned naked sovereign CDS trading a year ago but was unable to convince its partners an EU-wide ban was a good idea. The recent turmoil has brought this topic back to the table. Next month, the European parliament and the member states are to recommence talks on a variety of issues concerned with financial regulation and a sovereign CDS ban is expected to be among the topics discussed. On August 11, the German finance ministry said that it was “doing its utmost” to convince the EU to impose a comprehensive ban on naked shorts to combat “destructive speculation” in the markets. It did not specify that it was concerned with only the naked short selling of financial equities. The CDS market can expect another tilt at its integrity in the near term.


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