First, lemme give y’all a brief review of what short selling is.
In equities markets, short selling is a trading strategy where a trader sell securities that he doesn’t actually own, as he believes that the security is overvalued and that price will drop. The trader will “borrow” the security from another party (normally a brokerage) and sell the security in the open market.
Once price has dropped, he will buy back the security and “return” it to the lender. The difference between the rate he sold it at and at which he bought back the security will be the trader’s profit.
This strategy helps benefit the financial markets because it provides additional liquidity (more sellers in long-biased markets like equities and bonds) and limits the probability of price bubbles.
In the past, what some traders would do is that they would first sell the security in the open market, and then borrow the security from a third party. This is called “naked short selling”.
The risk with this of course, is that if someone buys those shares in the market but the trader has yet to “borrow” the security from a third party, he exposes himself to the risk that price rises quickly.
Moving on, the new regulations came into effect last Thursday, November 1. The new regulations will apply to all securities, including equities and bonds, which are primarily traded within the EU. Under the new rule, naked short selling will be banned, which means that all short selling transactions must be covered (i.e. the seller has borrowed the share before posting the sale).
Countries like Spain and Italy actually first implemented short selling bans back in July, and it’s only now that the regulations will affect the rest of the euro zone. The hope is that these new rules will help ease the increase in volatility, which has spiked thanks to all the uncertainty in the markets.
The new regulations will also ban investors from buying credit default swaps or CDS (a.k.a. bond insurance) on EU sovereign debt unless the investor can prove that he is buying the CDS as a hedge to an existing long position.
One way the EU plans to regulate this is to cut the time a manager has to obtain a stock after establishing a short position. In the past, managers would have a very lenient 30 days – now, they’ll only have 4 days to cover the position.
Moreover, regulation will also require all firms to report any significant short positions in the same format. This will help prevent companies from finding any loopholes in the rules.
Upon the announcement of these new regulations, financial market analysts were quick to point out that banning short selling could complicate matters for banks, hedge funds, and financial institutions. For one thing, a huge number of transactions won’t get executed and it could make disclosures more costly.
Also, this EU regulation marks the first time that the institution planned to regulate transactions abroad. According to financial lawyer Stephen Wink, this non-U.S. regulation would have a direct impact on U.S. traders and that it would be a real surprise for many U.S. market watchers.
Should forex traders be worried though? Well, maybe not for now. The ban only restricts short selling of European stocks, government bonds, and CDSs, which means that we can still short the euro for the time being.
Be mindful though that this could result in additional volatility for euro pairs as traders and investors who are betting against the euro zone will most likely transfer their trading activity to the forex market, which isn’t subject to short-selling restrictions at the moment.
Steve Barrow, currency and fixed-income strategist at Standard Bank in London, noted that this could result in stronger selling pressure for the euro as the regulation could result in a significant “reduction in the number of ways to express bearish positions.”