The ban on short selling will have a severe impact on derivatives as the banks turn off strategic transactions and have to deal within vanilla exchange traded products. Perversely the ban actually could increase the trades in equities, as traders will need to cover positions during the working day and only use exchange traded derivatives has a hedge against a risky position. This is in fact a return to the early seventies before options and futures became normal business practice and where short selling was covered by stock borrowing and dare I mention Contangos.

Another effect of the short selling ban could be the reduced volatility in the market as the investment banks and institutional investors will have to trade within a narrower field of products and where transparency in the market is instantly established. If nothing else the short selling ban will provide a perfect opportunity for the market to analyse the real impacts of OTC and derivative strategies on the underlying instruments. I hope all industry analysts, stock exchanges and regulators take this opportunity and publish the results of the research.

The results of the research on the short selling ban will be invaluable in assessing today’s market crisis and how remedial actions/rules or practices can be best implemented as the stock market emerges into some normality. I am certain that come the lifting of the short selling ban the financial markets will never be the same again. 

For many people that worked in the Stock Market in a bygone generation the over use of strategies where derivatives create a false market for the long term investor has been allowed to continue for far to long. Derivatives were designed to be a safety instrument allowing companies to hedge against acts of God against their business or as a protective measure against revenue and profit. Indeed restricting a potential loss was always a key value for Options and Futures.

The world started to go a little crazy when Contracts for Difference (CFD) appeared! Quite frankly these instruments have a proper home at the corner shop bookie rather than in respectable financial institutions.

The gluttony of the trader and their organisation holds no bounds with an enormous escalation of CFD business, turning quick profits for the punters and in turn increasing the market for the product. Other derivative products based on a similar construction, creating a huge share exposure to companies without risking any major investing capital will eventually reach a day of reckoning. Debt built upon debt will eventually cause the debt collector to call and it is the vulnerability of companies unable to influence the trader that will suffer as a consequence. In the extreme conditions we find today, the ebbing away of investor confidence can be fast and furious. Regaining confidence in the market will be long and arduous.

The increased volatility that derivatives brought to once sane stock markets has now been realised in the damnation of respectable financial institutions. Further than that though is the mess that most people in the civilised world have to endure without fully understanding the reasons why this has happened.

Derivatives are a vital part of the financial markets and the intelligent use of strategies to generate wealth is in itself not wrong. The issue arises through misuse of strategies to manipulate share prices to the detriment of the investor and the financial system in general

Short selling is a fundamental tool to increase liquidity in the markets and as such provides investors with a valuable capability that can service the investor well. The problem becomes serious when the short sale is allowed to be uncovered by another asset at least equal in value to the position. Margining is a necessary cost and a protection for the investor but also all market participants. The financial system has broken down but now we have a unique chance to analyse and create something far better and far less risky and a short term hit on derivatives looks worth the price.

By Gary Wright