Germany's short selling ban won't stabilize anything

(Fortune) -- Late Tuesday in Europe, German authorities announced they would temporarily ban naked short selling of certain financial institutions and buying of naked credit default swaps of European Union government bonds. Perhaps not surprisingly, the U.S. equity markets sold off on the news and the reaction from European markets Wednesday was just as predictable, down 2 - 3.5% across the continent.

The SEC experimented with a short selling ban in late 2008, which should have been a lesson for German authorities. On September 18th 2008, the SEC banned short selling on certain financial institutions, with the stated intention to "protect the integrity and quality of the securities market and strengthen investor confidence." The immediate term impact of the short selling ban was a one-day short squeeze in which the financial sector rallied, but longer term, the ban provided no increased investor confidence in the financial sector.

In the chart above, we have graphed the XLF, which is the S&P financial sector exchange traded fund, or ETF, that tracks financial institutions. The XLF peaked on September 19, 2008, the day after the ban, at $22.38 and then began a six month slide and finally troughed at $6.26 - a 72% overall decline for the sector.

Admittedly, the SEC may have limited volatility in the sector in the short term, but the only investor confidence that seemingly followed the ban was confidence in an orderly unwind and decline.

In contrast to the SEC's statement, the primary issue with an arbitrary and unilateral changing of the rules as German authorities instituted yesterday was that large investors actually lose confidence in the market, as evidenced by the stock market action yesterday. They potentially lose their ability to hedge, and to make directional bets more broadly. Aside from an intention to create stability in the European markets as the SEC intended a year and a half ago, Chancellor Merkel actually went a step further with her statement:

"The lack of rules and limits can make behavior in financial markets driven purely by the profit motive destructive and lead to an existential threat to financial stability in Europe and even the world. The market alone won't correct these mistakes."

In essence, Merkel's repeating the tired mantra in which stock market operators and investors who make fundamental bets are blamed for any decline in markets. In reality, real and fundamental sovereign debt issues have created an existential threat to financial stability in Europe. While certain investors may be trying to profit from these opportunities, they certainly didn't create these problems.

The risk of the German ban on short selling is multifaceted.

First, it potentially is the beginning of future regulation in Europe that may limit the two-way flow of markets. The reality is that large fixed income investors, may no longer feel they can adequately hedge their positions, or that there will be ample market liquidity in the future to exit their positions.

Second, the ban is a signal to the markets and investors that more bad news is to come. As a result, investors could quickly lose even more confidence in European debt markets and view this German action as harbinger of increasingly negative fundamentals in Europe. This actually seems likely, since in the short term we have already seen issues with nations getting the funding they require, despite the $1 trillion ECB bailout plan. Specifically, Spain had planned to issue 8 billion euros of short-term notes yesterday, but the auction failed to attract enough bids, so the sale was reduced by 20%. This is the first time Spain has ever had a reduced debt auction.

Finally, there is risk that Germany is instilling measures with the intention of make an unwinding of Greece in a default scenario more streamlined. That means in effect, Germany is preparing for the inevitability of a default, or defaults, in Europe.

The political benefit of this is that it would be difficult for investors to profit on the massive decline, so at least the German government could argue the "evil doer" hedge funds didn't benefit. The market reality, though, is the naked short ban could actually accelerate a decline in confidence in European debt markets, which would ultimately accelerate any potential defaults.

Daryl G. Jones is the Managing Director of Risk Management at Hedgeye, a research firm based in New Haven, Conn. His colleagues Darius Dale also contributed to this column.