Short SellingFollow

I'm sure most of you have heard about the situation in Greece. For those that haven't, here's a quick recap.

I have a good mate who's a banker for HSBC. He's been telling me for 3 weeks that he's been selling lots of CDS on Greece defaulting. According to him, that's a relatively new trend, since CDS are usually for private firms. What this means in practice, and maybe Smash will scorn me for my poor economic literacy skills, is that people basically "bet" on Greece defaulting on its huge debt. The more investors bet on Greece defaulting, the more the interest Greece has on its debt goes up, making it harder for Greece to repay its debt, which in turn heightens the chance of Greece defaulting. It's a vicious cycle, one that was applied to banks and financial institutions during the crisis, and which is called "short-selling".

Isn't that "wrong"? Shouldn't "short-selling" be banned? I'm struggling to think of waht positive purpose this kind of financial transaction serves.

Secondly, isn't a bit rich for these firms who had to be bailed-out by governments to now make money on betting against those very governments? Is it just me, or is this whole system just completely fucked-up?

Finally, what do you guys think of the Tobin tax? Do people even talk about it in the US?

No. Short selling should not be banned. In practice it would essentially bar you from selling something of value that you own, or purchasing something of value that you do not and would otherwise be perfectly entitled to purchase at the going rate. That violates every ideal of capitalism and free enterprise.

The firms, on the other hand, shouldn't have been bailed out in the first place. That they now profit from the carnage is merely the law of unintended consequences coming back to bite short-sighted governments in the ***. I have zero problem with that.


I'm curious on 2 fronts:
What is a realistic retirement age? Are you referring to a blanket age at which people are allowed to retire or simply the age at which retirees are eligible for government benefits?
What is a fair tax? Are you referring to the rate "rich people" have to pay or the need for everyone to pay, even the **** poor?

Edited, Feb 24th 2010 7:43am by MoebiusLord

The linked article didn't mention short selling specifically, but it's clear enough to see what's going on. First off, unless the laws in Greece are significantly different, every single short position on something (whether in a stock, bond, or commodity market), must be matched with an equivalent "long" position. You're selling something at todays price, with the promise to buy it down the line for a lower price. Someone else has to agree to buy it today at the higher price and someone else has to agree to sell it at the lower price in order for the numbers to work. In theory, the net effect on the market from doing this should be zero. However, there are examples of large volumes of calls for shorts to create a crash (similarly, a whole lot of trades in the other direction can artificially raise the value).

Bond markets are trickier than stock or commodity markets because it's not the value of the thing that is at issue, but the relative interest and exchange rates. Same principles apply though. However, the government itself may take an interest in keeping those rates at certain levels, which means it might take the long position simply to stave off a short term fluxuation. This is kinda like eating your own limbs to prevent starvation, but in economic terms, it works in the short term (with some negatives in the long term of course). It does create a condition where private citizens can choose to take a short position and drive the economy into the dirt though...



In principle, no. However, governments and central banking institutions need to be aware of the ramifications of this and account for it. Unfortunately, it's one of those "in for a penny" sort of deals. The broader practice of short selling isn't a bad one (and some would argue is necessary for market liquidity). It's those occasional really tricky situations which can cause problems though...



Yes. Which is why *how* you bail out banks is as important as actually doing it. A government should take pains to make sure that the risk they are putting themselves into by doing so doesn't outweigh the risk of harm they are attempting to avoid. Unfortunately, when times are good, we tend to forget this, and saddle governments with all sorts of assumed risks in order to protect our fortunes, and those things bite us in the rear when things go bad.



I think the idea causes as much or more harm as it prevents. It'll mute profits on currency trading (and currency trading as a whole) during "good times", while focusing such on just the extreme rate differences in "bad times". It effectively raises the bar for profits in the currency markets, focusing every single trading dollar (or whatever) into the most unstable markets, thus making them worse. In short, it wont stop the kinds of problems it's designed to stop (and may even make them worse), but it'll create blockages in legitimate currency trading by making it less profitable. Kind of a lose/lose, without much upside.

Bear with me. How does it do that? is it simply the process of selling and re-buying the share that creates "liquidity"?

I guess what I'm failing to grasp is the point at which the wealth created by these kinds of transactions actually effects the economy. From what I gather, all these kinds of deals do is move money around. It doesn't actually "create" any. While some guy creates money on short selling, some other guy(s) is clearly losing some at the same time. Short-selling is a zero-sum game, no?

In market terms, yes. Liquidity in that context means the ease with which a product can be bought or sold. A high existing volume of transactions means higher liquidity for the simple fact that if you want to buy or sell, it's easy to do so.

Imagine walking into a town in which every single inhabitant owns their own farm and grows every single thing they need and makes everything themselves. No one trades anything with anyone else. You, as a guy traveling through town would find that your currency is worthless because there's nothing to buy. Even if you brought something to barter, you'd have a hard time trading because everyone already has what they need (or is used do doing with what they have). The lack of an existing market means it's harder for someone to walk in and buy or sell anything.

Same scenario in a town where everyone produces one and only one good and must trade with everyone else for other things. There will be a robust market as a necessity, which means that a guy wandering through will find it easy to buy or sell anything he happens to have for whatever he happens to need.


That, in a nutshell is the principle of market liquidity. The mere volume of transactions is "good" in that it allows for greater ability for new transactions to occur. In a broader sense it makes new products easier to adopt. If you walk into town with a newfangled gadget called a "tractor", you'll find it much easier to get people interested in obtaining it in the second town than in the first. Assuming the tractor improves productivity for the town, this is a good thing for everyone...




The transaction itself is. There's kinda two different concepts at play here though. Volume and direction of transactions can create a (sometimes artificial) supply/demand effect. Even if every buyer must be matched to a seller, the mere fact that more people want to sell than want to buy will drive the price down (and vice versa of course!).

None of that "creates wealth" though. It at best (or worse) displaces it. However, wealth can be created via the process I outlined above. Higher market liquidity makes it easier for new transactions to occur. The very fact that money is moving around in the market and will generally attempt to seek out the most profitable ventures will result in more likelihood of funds landing somewhere that results in a process improvement. One can easily argue that the only thing which actually increases wealth are those things which make it possible to make more of something with less of something else. All that extra money floating around just kinda greases the wheels of that process though. We can't know always what things will cause efficiency improvements, but the existence of large volumes of money flowing around will guarantee that they will occur, and at a rate somewhat relative to the volume of money.

How currency transactions fit into this concept is much more complex, but that's sort of the simple version...

Ok, thanks for that Smash. I need a few days to think it over, and I'm sure I'll come back with some more non-sense I need explained :)

I like it, mostly because it breaks down the whole HFT shenanigans.

That is, unless Goldman wants to cut me in on it.