Chapter 12: Executive Summary – Short Selling

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section IV: Derivatives, Short Selling and Transparency

Background Until the current global financial crisis, the practice of selling shares that one did not own, known as short-selling, was generally permitted in most countries.  Of course, there were some restrictions placed on such transactions, such as the requirement to borrow the stock prior to the sale (“no naked shorts”), selling at a higher price than the previous trade (“the uptick rule”) and disallowing short-selling to capture gains and postpone tax payments (“no shorting against the box”).

In a dramatic decision in the early weeks of the current crisis, the SEC banned short-sales of shares of 799 companies on September 18, and subsequently lifted the ban on October 8, this year. However, most countries around the globe, and in particular, the U.K. and Japan, homes to the two other major world financial centers, London and Tokyo, have declared a ban on short selling for “as long as it takes” to stabilize the markets.  Even in the U.S., there is continuing pressure on the regulators to reinstate the ban, at least in selected securities or to bring back the “up-tick” rule.

Chapter 10: Executive Summary – Derivatives – The Ultimate Financial Innovation

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section IV: Derivatives, Short Selling and Transparency


Derivatives are financial contracts whose value is derived from some underlying asset. These assets can include equities, bonds, exchange rates, commodities, residential and commercial mortgages. The more common forms of these contracts include options, forwards/futures and swaps. A considerable portion of financial innovation over the last 30 years has come from the emergence of derivative markets. Generally, the benefits of derivatives fall into the areas of (i) hedging and risk management, (ii) price discovery, and (iii) enhancement of liquidity. Even in the current financial crisis, the derivative scapegoat, credit default swaps (CDS), has played some positive roles. For example, CDSs enabled lenders to hedge their risk and offer loans. When the securitization market for loans, bonds and mortgages shutdown in the summer of 2007, a number of financial institutions were left holding large loan portfolios. Using the CDS market, some of these financial institutions smartly hedged out their risk exposure. In addition, CDSs and other credit derivatives have played a very important role in disseminating information to both the public and to regulators: from judging the quality of financial firm’s bankruptcy prospects in a remarkably prescient way, from providing credit risk estimates that were central to the U.K. government’s bailout plan, and from revealing in early 2007 declines in values of subprime-backed assets.