The move sparked a panic, wiping billions from the value of shares while the euro hit a four-year low against the dollar, dipping beneath $1.215 before later recovering to $1.232. Said one trader: "The feeling is, what do they know that we don't?"
That sentiment led to a stampede for safety that wiped 149.26 points from the FTSE 100, which closed at 5158.08, a fall of 2.81 per cent. Germany's main stock index, the DAX, lost 2.72 per cent while the CAC 40 in France fell by 2.92 per cent. The sell-off was also felt on the other side of the Atlantic. The Dow Jones Industrial Average was at 10391.54, down -119.41 points or 1.14 per cent, by lunch time in New York.
But bond prices rose on the news, which meant that yields fell and the cost of borrowing to Germany and even to Britain, decreased. Ten-year UK government bond yields moved down 6 basis points from 3.69 per cent to 3.63 per cent. German debt reacted in the same way with 10-year bund yields falling by 8 basis points from 2.82 per cent to 2.74 per cent.
The ban imposed by German financial regulator BaFin prevents "naked" short-selling, a risky type of bet, of euro-denominated government bonds. The ban also applies to shares in the country's 10 most important financial institutions and to some credit default swaps. BaFin said it was prompted by "extraordinary volatility of the bonds of eurozone states" amid mounting concerns about possible "speculative" attack by hedge funds on the debt of the eurozone's weaker members, particularly the so called "Club Med" countries of Greece, Spain, Portugal and Italy.
In addition to warning that the single currency was in danger, Ms Merkel urged speedy action to stop what she called market "extortion". The German Chancellor said the EU needed a process for "orderly" insolvency of members and recommended tough action against "notorious deficit sinners" in the eurozone.
That could include measures such as withdrawing voting rights. Ms Merkel told the German Parliament in Berlin: "Above all, what's necessary is to develop a process for an orderly state insolvency... with that we would create an important incentive for eurozone member states to keep their budgets in order."
However, while the ban was intended to curb the activities of speculators, whom Germany fears have been running rampant across the continent, which has sowed instability and causing wild gyrations in markets, it was responsible for some wild gyrations of its own.
But economists and traders were sharply critical of the ban, warning that it would have little real impact in the absence of co-ordinated action from other financial centres and had served to make a bad situation much worse by shattering wafer-thin confidence.
David Page, economist with Investec, said: "There's been an all too predictable reaction to what was an unpredictable move from the Germans. There is still a hive of uncertainty in the markets regarding eurozone debt. Germany has made a slightly oddball move that suggests that it is worried about debt. It is unlikely to achieve its aims because what it has done is heighten the uncertainty. The only upside is that the eurozone bond spreads haven't risen by that much."
Manoj Ladwa, senior trader at ETX Capital, said: "Angela Merkel's knee-jerk reaction to ban speculators from short-selling debt has sent the markets into a tailspin. The reverberation of her decision is likely to have a serious negative impact on not only the euro, but also other European countries who may impose a similar restriction."
David Buik, partner at BGC Partners, said: "This is the most insane thing I have heard of since Noah left the Ark. It cannot achieve anything because it can still by done in London, in Paris, in New York. But what it has done is put the markets in a real spin. The problem is they are really sensitive at the moment and sentiment-driven and something like this, which is unexpected and out of the blue, can really knock sentiment."
Jeremy Batstone-Carr, analyst at Charles Stanley, said the ban's motivation was political: "The timing of the move is significant insofar as it comes shortly before the German parliament initiates the debate on the bill to authorise the €123bn German contribution to the €440bn emergency support fund for the indebted European nations."
While all major parties appear in favour of this, many Germans remain deeply unhappy.
Naked shorting: A speculative gamble
Naked short selling sounds like a bizarre form of gambling, and in many ways, that is exactly what it is.
Short selling shares or bonds is a long-established practice in financial markets. It works by a trader borrowing shares from an investor – typically a bank or an insurer – for a fee. The trader then sells the shares (which are returnable on demand) on to the open market. This is done in the hope that they will fall in value. The trader can then buy them back at a lower price to return them to the original owner at a profit.
Naked shorts, however, add an additional complication. A naked short occurs when a trader sells a share, or a bond, before they have actually been borrowed. With the help of intermediaries, this can be done with shares or bonds or even foreign exchange.
One of the problems with "ordinary" short selling is that to accomplish it, you need to find someone to lend you the stock. But there are many institutions that are unwilling to lend. So, during periods of exceptional volatility in the markets and when people are trying to short companies whose shares are tightly held, naked shorting comes in.
A naked shorter opens up a sell order usually before even checking that there is someone to borrow the stock from. But the order appears on screens around the City anyway. As long as they can ultimately secure supplies of the stock (and most of the time they can) the trade goes through. When a large number of people do this, a rush of sell orders appear on screens. Buyers run scared and the price tumbles. It's seat of the pants stuff and doesn't always work, but when it does, prices can fall spectacularly. This is what is known as a "speculative attack" and is what has regulators in Germany so upset.
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