EFA (48): Naked short selling

In the 48th instalment of our regular series, Economics for Amateurs, we are going to look at what happens when you put three simple English words together: "naked", "short" and "selling".

I am sure that you don't need me to explain what any of these words means individually. But what on earth do they mean together?

Let's start with the word "selling". This could refer to real assets, such as commodities; financial assets, such as shares or bonds; or derivatives. Derivatives are financial instruments derived from real or financial assets. For example, an option to buy a share is a derivative. For more, see here.

What about "short"? Well, "to sell something short" means to sell something that doesn't actually belong to you. For example, you could borrow shares (for a fee), and sell them in the hope that you can buy them back later at a lower price, and make a profit on the deal.

In other words, short selling is a gamble that prices are going to fall. In 2008, after the start of the financial crisis, a number of countries banned short selling temporarily to reduce the risk of a further stock-market crash. For more on short selling, see here.

So now we come to the "naked" bit, which is not quite as interesting as it sounds. It is, however, linguistically logical: the seller is not "covered"; he is selling an asset or derivative without borrowing it beforehand.

Opinions differ on whether short selling — and, particularly, naked short selling — makes financial markets more volatile, by encouraging speculation, or more efficient, by providing necessary liquidity. See here for a discussion of some of the issues.

Recently, there has been heated debate about another form of naked transaction, relating to derivatives called credit default swaps (CDS). These are, in effect, insurance policies against the risk of a borrower (a company or country) defaulting.

The debate centres on whether it should be legal to buy such insurance without owning the underlying asset (for example, Greek bonds). Opponents, such as Wolfgang Munchau at the Financial Times, argue for a ban on naked CDSs.

An analogy is made with other kinds of insurance. For example, you can't take out insurance on a house you don't own. Otherwise, you would have a clear incentive to burn it down. By analogy, buying insurance against, say, the risk of the Greek government defaulting, when you don't own any of its bonds, is seen as encouraging speculative attacks against such bonds.

A more positive view of naked CDSs comes from Munchau's FT colleague Sophia Grene. She argues that you can be negatively affected by a company's or country's default even if you don't own their shares or bonds. And therefore, you might want to insure yourself against this risk.

The debate is likely to run for a while and end in greater control but no outright ban of naked CDSs.