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No Naked Shorts!

How naughty-sounding behavior on financial markets became an international fiasco.

A column on the euro just published in the new issue of Miller-McCune was overtaken by events in late May, when Angela Merkel came out — unexpectedly, single-handedly — in favor of a ban on "naked short selling" on international markets as a way to defend the euro from speculative attack.

I wrote that world governments should consider banding together to pass uniform laws against naked short sales. In the meantime, of course, most people have heard that Merkel's lonely attempt to do just that sent stock markets into a nosedive. Her move made traders wonder what else Merkel knew about the euro-zone economy that might require such a sudden and unilateral change of rules.

But a ban on naked short selling is still a good idea, since it can help keep markets honest.

First, some definitions: In a regular short sale, a trader locates shares in some stock, promises to buy them in the future, and makes money when the value drops. In a naked short sale, the same transaction occurs without the formality of claiming actual shares to borrow.

Chancellor Merkel, specifically, wanted to stop naked trades in credit insurance on government bonds. Markets that allow these "naked swaps" effectively hand out fictional claims like vanishing cards from an endless magical deck. Without an anchor to real slices of (say) credit insurance, prices distort. Traders are then betting in a sort of fantasy world on the creditworthiness of government debt, but the fantasy world can change the terms of the debt itself — making default likelier, in Greece's case — while the trades go undisciplined by a real supply of shares.

EUROPEAN DISPATCHMichael Scott Moore complements his standing feature in Miller-McCune magazine with frequent posts on the policy challenges and solutions popping up on the other side of the pond.

Michael Scott Moore complements his standing feature in Miller-McCune magazine with frequent posts on the policy challenges and solutions popping up on the other side of the pond.

So a ban on naked shorts makes sense. But it needs to be worldwide. For a single government like Germany to announce it overnight is silly. The reasons for Merkel's odd behavior could be grist for another column, but a ban on naked short selling should, at the very least, be EU-wide. That may be just a matter of time, but even so the more frivolous risks to the euro wouldn't end until the U.S. and Asia agree to a similar ban. Traders can buy these derivatives on sovereign debt on any market in the world.

A naked-short ban dropped out of the U.S. Senate's finance bill in May, around the time Chancellor Merkel announced the German rule. American arguments against a ban tend to focus on short selling itself, saying "the market needs bad news," not to mention the easy money of high-risk gamblers who want to make these innovative naked bets. All investment, they add, is speculation.

Sure. But the argument continues that these short sales are just a barometer, a way to measure creditworthiness, when it's clear that some highly unusual derivatives can actually change the bare cost of servicing a national debt.

"Bank toadies who unintentionally conflate straight shorting with naked shorting because they do not understand the difference," argues Bali Randhawa at Seeking Alpha, are worthless if not suspect. "The former [straight short selling] is a legitimate market practice that no one advocates banning; the latter is fraud, which if it were done not by a $500K a year refined huckster but by a two-bit hustler would bring about a visit from the Secret Service."

The euro area has seen these troubles before. One purpose of the euro was to guard against such fickle and treacherous weather on financial markets. When speculators turned against the franc in the early 1990s, French President François Mitterand held secret meetings with his European counterparts to shore up support.

"The Franc nearly succumbed," he complained to Italian Prime Minister Giuliano Amato, in a meeting recounted by David Marsh in his history The Euro: The Politics of the New Global Currency. "It is intolerable. There is no reason why the policy of a state should be at the mercy of volatile capital which does not represent any real wealth, or creation of goods. It is an intolerable immorality."

"I agree with you," Amato said.

"It has to stop," Mitterand said.

"... We need to go further down the road of integration," Amato said.

By the end of the '90s, European currencies had integrated, and the euro came to be. But the most recent crisis shows that the currency — even if it's not doomed — is no less vulnerable to "innovative finance" than the stalwart monies it replaced.