Spain has recently banned the short selling of its debt (government bonds). This move has been greatly critized by many analysts as shooting the messenger instead of solving the problem. But isn't shortselling part of the problem? That's what I will discuss in this post (hint: things are always more complex here..)
Short selling, or shorting, is the process of selling an asset that you don't posses. This wikipedia page explains it all quite well. The short version: When you short you sell an asset that you have borrowed. Later you buy that same asset and return it to the borrower. With this proces you're actually betting on a decrease in value. A more devious business is naked shorting where you do not borrow the asset but sell it anyway. After the asset has decreased in price you quickly buy it and complete the previous selling transaction
Interestingly shorting is a neutral action, since there is both a selling and a buying transaction. This also holds true for naked shorting. It is because of this that traditional economics expects no long term effects from these practices. Actually shorting increases the value of the asset for two reasons. The first is that the buying and selling transactions create more liquidity in the market, giving other players the opportunity to easily buy and sell that asset. The other enhancing value is that it allows players to lend their assets to these speculators and thereby increasing the return of it.
So if shorting is good for the value of the underlying stock, why ban it? First massive shorting creates a surge of assets on sale thus depressing the price. This is later compensated, but it will depress the price for some time. In the case of naked shorting the number of assets on sale can actually be larger than the total number of assets, leading to a very unstable market. There is also a psychological issue: massive shorting signals a distrust in the asset, and issuers of the asset (e.g. the Spanish government) generally do not like that.
Thus it seems that banning shorting is in fact shooting the messenger, but it is not the whole story. The financial markets have another unnamed aspect: uncertainty. Most players, mainly conservative ones, rely on other players to gain information on an asset. When an asset is massively shorted, many long term players will also leave the market out of fear that there is unknown information. Even if the players don't leave immediately the strong variations in price, due to massive buying and selling, will create a distrust by themselves. Therefore massive shorting does actually bring down the value of an asset.
There are many ways to deal with shorting: the most mature way is to accept shorting as an inevitable side effect of trading in your asset. For most cases shoring does not affect the price of the asset in a great matter itself. However there are cases were action needs to be taken.
This is when a massive shorting campaign on your asset is taking place. Simply banning the shorting of your asset will drive out most long term holders, since they can't rely on the liquidity and the extra income provided by shorting. This will then result in a non-neutral action on your asset driving prices further down. Even worse, since long term holders do not like to be in your asset anymore the price will remain depressed.
The only other way is to keep the price from your asset up, since shorting and especially naked shorting is often only for a small period of time. It is only necessarily to keep the price up for some time. This can be done by buying up the asset under covert plans. By doing so you actually reward the holders of your asset while you punish those that doubt you. Precisely what you'd want to achieve. Therefore don't ban the shorting of the stock but strongly discourage massive shorting.
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