In an unexpected move, Germany announced a unilateral ban on naked short selling of shares in 10 German banks and insurance companies that will come into force immediately and remain in place until the end of next March.
Short selling is a practice whereby a trader “borrows” stocks or bonds from another financial institution in anticipation that their value will fall. Obviously, the trader must pay a commission to the lender to make it worth their while to lend the stock. If the stock does fall then the “borrower” returns the same volume of stocks to the lender, but has paid a cheaper price for them since they were actually purchased after the fall. The trader makes a profit based on the difference between the initial and final value of the asset. Of course, if the market rises the trader will get their fingers burned. The lending institution will have a long-term interest in the stock that was traded (believing that its value will rise ultimately), but has made an additional income from holding the stock in the interim.
By the nature of the beast, short selling only works in a falling market and may lead to a weakening of sentiment that send markets even lower. The mechanism can be used for trading bond and currencies just as easily as for stocks. In a naked short sell, the “borrower” doesn’t even have the assets in their possession when the trade is made. The German ban extends to “naked credit-default swaps of Euro-area government bonds” as well.
German financial authorities moved because of “exceptional volatility” in Eurozone bonds. They believed that substantial short-selling was endangering the stability of the wider financial system. It is unclear whether the move will be followed by other Eurozone members.