More Thoughts on Germany's Move

German financial regulators announced an immediate ban on naked short sales of European government bonds, credit-default swaps, and shares of the top ten banks and insurers. This appeared to precipitate new euro selling that continued through the North American afternoon and into early Asian trading.

Market participants concluded that the move was ill-thought out, uncoordinated, and likely ineffective. This would seem to be yet another case of a European government taking the wrong fork in the road.

It is possible that other euro zone members may duplicate the German initiative. Although much has been made in the press of the tensions between Germany and France over the ill-named Stability Mechanism (May 9th), but France's Sarkozy appear quite sympathetic to enhancing European financial regulation, for example. Surely Greece, Spain and Portugal cannot be too opposed to similar measures.

The unilateral aspect of the German initiative, however, is disconcerting, especially in terms of the CDS market. First, most CDS activity does not take place in Europe but in NY. German or even European restrictions can be gamed (i.e. move the restricted activity offshore). Second, the Deposit Trust & Clearing Corp, a registry and clearing house of information on the CDS market reportedly indicated that outstanding credit default swaps on ten European countries, including Greece, Spain, Portugal and Italy was less than $108 bln. The entire CDS market is estimated to be around $11 trillion.

German Chancellor Merkel was quoted on May 6th suggesting that "In some ways it's a battle of the politicians against the markets. I am determined to win. The speculators are our adversaries."

This is probably an exaggeration of events and reflects a mis-understanding of speculation. Speculators do not attack the strong, but the weak and vulnerable. Perhaps the best way Europe can minimize the role of speculators is not to try to regulate them away but pursue more credible policies. Merkel is misguided, speculators are not the main adversary, but symptoms of the problem. The real adversary is no longer Greece. The real adversary may be the policy response of the very politicians Merkel claims to speak for.