Friday, September 17, 2010

Restrictions for Naked Short Sellers

I fully agree with the recent directives by the European Commission to safeguard the Europe financial markets. Frequent traders of some OTC derivatives in Europe will have to use central clearinghouses to close sales, while naked short-sellers would be required to submit proof they can access the underlying security to settle a trade designed to profit from falling prices. There is no mention of the penalty though if they are caught breaking the rules. I assume they are fined many times of the total cost of their transaction. The penalty must be high enough so that people will think twice before doing naked shorts.

I especially agree with the ruling on the naked short-sellers because they distort the market. Short sellers borrow assets and sell them, betting the price will fall, buying them later and pocketing the difference. In naked short-selling, traders never borrow the assets, so betting is unlimited. If your betting is unlimited, your demand and supply in short, screws up. How would the price of the asset reflect true demand?

The only disappointment is that this only applies to Europe. This should be the standard rule for the world financial markets.

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