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 11: Executive Summary – Centralized Clearing for Credit Derivatives

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


Credit derivatives, mainly Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDOs), have been under great stress during the sub-prime financial crisis and have contributed significantly to its severity.  In large part this is because these relatively new products are traded in bilateral transactions over-the-counter (OTC), unlike other major financial derivatives that are traded on exchanges.  OTC contracts can be more flexible than standardized exchange-traded derivatives, but they suffer from greater counterparty and operational risks, as well as less transparency.

Chapter 7: Executive Summary – Corporate Governance in the Modern Financial Sector

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section III: Governance, Incentives and Fair-value Accounting


The large, complex financial institutions (LCFIs) are highly levered entities with over 90% leverage. This highly-levered nature makes them prone to excessive leverage- and risk-taking tendencies.  By and large LCFIs also have explicit deposit insurance protection and almost always an implicit too-big-to-fail guarantee.  The presence of such guarantees – often un-priced and at best mis-priced – has blunted the edge of the debt monitoring that would otherwise exert an important market discipline on risk-taking by these firms.  Although there is mounting evidence pointing to weaknesses in equity governance of these firms, the high leverage they have undertaken and the failure of their internal risk management practices also suggest weakness and failure of regulatory governance.

Time to Lift the Veil

A clearinghouse for credit derivatives trading? The severe stress in the credit derivatives markets since the inception of the sub-prime crisis has been reported in great detail in the financial press. Hitherto arcane CDOs and CDSs (Collateralized Debt Obligations and Credit Default Swaps) have become part of the popular vocabulary. An important aspect of these markets is that these products are traded over-the-counter (OTC) in bilateral transactions between banks and other institutions. In this sense, they are fundamentally different from other financial instruments such as stocks or equity options, which are mainly traded on exchanges. This distinction has many implications, the most important being that relative to exchange trading, OTC markets feature greater counterparty and operational risks as well as lower transparency. Counterparty risk arises from uncertainty about whether one side of the trade will fulfill its obligation in future. Operational risk arises from uncertainty about whether trades will be cleared and settled in an orderly manner by counterparties. Differences in transparency arise from the fact that information about trading volumes and prices is easily available in the case of exchange-traded markets, while in the case of OTC products it is difficult to obtain such data, and hence trading is more opaque.