Regulators, meanwhile, are now prepared to use almost any tool to try to stabilise financial firms and prevent the kind of death spiral suffered by Lehman and AIG. To this end, authorities across the developed world have introduced blanket suspensions on the short-sale of financial firms shares, and are eyeing curbs on credit derivatives.
As a matter of justice, the constraints on short-sellers, who bet that share prices will fall, are cruel. Some bears played a big role in uncovering the folly that banks were engaged in. Nor does it seem likely that their trades distorted prices. In the week before AIGs rescue the net increase in its stock on loan (and thus available to be sold short) represented only 5% of trading activity, based on statistics from Data Explorers, a research firm. Even on grounds of expediency the actions are questionable. Some financial shares covered by the ban have since plummeted.
In addition to their unconvincing experiment with short-selling, regulators have turned on credit-default swaps (CDS), contracts which insure against default. Some intervention is certainly needed to limit the systemic risk posed by this largely unregulated, over-the-counter market. The Federal Reserve Bank of New York is helping to create a central counterparty for CDS trades, which should prevent the kind of disruption created by the collapse of Lehman, a big CDS dealer. And the governor of New York State wants companies that sell CDS to insure customers bond portfolios from default to be subject to solvency rules. That should help prevent a repeat of the AIG debacle. A poorly capitalised subsidiary of the insurance firm was relied on by many banks for credit protection.
Yet as well as being a shambles, the CDS market now stands accused of being a speculators playground. One conspiracy theory is that hedge funds distorted CDS prices, which spooked the stock market and caused a collapse in confidence. Even the Chairman of the Securities and Exchange Commission, Americas financial regulator, says significant opportunitiesexist for manipulation.
CDS dealers insist this is unfair. One estimates that speculation represented only a quarter of recent trading volumes in distressed financial firms such as Lehman, with the bulk of activity involving rival firms desperate to protect themselves against counterparty risk. There was a comparable slump in cash bonds, which for technical reasons are hard for speculators to bet against.
Still, taking into account estimates of trading volumes and margin payments, it is conceivable that an individual hedge fund, if it had no regard for counterparty risk, could have dominated trading of an individual banks CDS on any given day. Unless the market becomes more transparent, it will be hard for its supporters to refute such allegations.
One way of viewing the crackdown on speculation is as a purgative that will force sloppy markets to clean up their act. Yet there will also be a cost. Already absurd situations have arisen: somehow IBM, a technology company, has managed to get on the list of stocks protected from shorting. In the long run short-sellers, who improve liquidity and price discovery, will be wary of trading the shares of politically important industries. In America, one bear complains, it is now capitalism on the way up, and socialism on the way down.
The Economist Newspaper Limited 2008