Streetwise Professor

June 13, 2009

Back to the Future: Naked Short Edition

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 6:54 am

Recent legislative proposals would outlaw short selling of credit default swaps, i.e., only bond owners can buy protection.  (Remarkably, such a provision is included in the Waxman-Markey climate change bill.)  As if to prove that there is little new under the sun, Larry Neal of the University of Illinois presented a paper at the Manufacturing Markets Workshop in Florence, which closes with the following:

The most enduring, and ultimately most controversial, piece of legislation to arise in the eighteenth century was Barnard’s Act (7 Geo. II, cap 8).  Parliament passed the act originally in 1733 for a period of three years to see what effect it might have and then made it permanent in 1736 after it appeared that the limited number of securities available had not suffered any adverse effect s of the act. . . . The act was intended to eliminate time bargains in public securities altogether by requiring the seller of government stock for a forward contract have possession of the stock at the time of the contract, essentially eliminating options business on forward contracts or the settlement of forward contracts by paying the cash difference between the forward price agreed and the spot price at the time agreed for the completion of the contract.  Sir John Barnard thought that this would eliminate sudden movements in the prices of various forms of government debt by eliminating the pernicious business of stock-jobbing.

After his presentation, Larry noted to me that the primary effect of the Act was to drive forward trading from London to Holland.

I’ve been critical of current legislators and the Administration for seizing on a regulatory framework mandating exchange trading first established in 1921-1922 to serve as the model for current regulatory proposals.  Perhaps I was too critical: an early-20th century precedent appears progressive indeed, as compared to the early-18th century precedent of the short sale ban.  

In a nutshell: these various “new” regulatory proposals are not new at all.  They have been tried before.  And found wanting.  They are simplistic, based on a misdiagnosis of the operation of the market, and are nostrums that will at best will not make things worse, although it is more likely that they will dramatically reduce the efficiency of the market and may well increase systemic risk.  Another example of “learned nothing, forgotten nothing.”

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  1. If we are attempting to diagnose efforts for change, as well as the current operations of the market, perhaps dismissing proposals solely on the basis that they have been tried before is unwise. Afterall, peace amongst nations is an old idea, resurfacing periodically as the mushroom cloud of smoke clears. If new rules, or for that matter old rules newly applied, drives market share to Holland, so be it. How much does a tulip bulb cost now anyways? To the point, is it efficient to keep the short selling of credit default swaps? I would be happy if someone could even clearly define what such an animal is. Further, a naked short is different from short selling. A little knowledge is a dangerous thing, especially if we are to believe that the real threat to our economy is the driving away of money, (is a transaction really “money”?), offshore to the loose and fast playing Dutch.

    Comment by Charles Longfellow — June 13, 2009 @ 6:13 pm

  2. So the bill says that only the entity that is holding the bond can purchase a CDS, correct? What about the party that is writing the CDS? Seems to me there is more risk is writing CDS than purchasing them. Maybe I am not understanding this correctly…

    Comment by Todd — June 14, 2009 @ 8:25 am

  3. Todd–Purchasing a CDS is equivalent to shorting the bond.

    The ProfessorComment by The Professor — June 15, 2009 @ 3:50 pm

  4. Liquidity could be infinite if an unlimited number of shorts are allowed without some measure of covering. The Wiki attempts to decscribe the problem at:

    Comment by Charles Longfellow — June 15, 2009 @ 4:37 pm

  5. Since SWP is the master of detecting market manipulation, I guess we can expect some enlightenment on the state of the art in detecting naked short selling to manipulate prices. Did any such manipulation occur prior to the going down of Bear Stearns and Lehman, as alleged?

    Comment by Surya — June 17, 2009 @ 6:37 pm

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