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Q+A: How will Germany's short selling ban impact markets?

LONDON (Reuters) - Germany banned naked short-selling of certain financial instruments on Wednesday, sending the euro and European shares lower and raising concerns over market liquidity.

German financial watchdog BaFin said the ban had been imposed “due to the extraordinary volatility in government bonds in the euro zone” and warned that massive short selling could have endangered the stability of the financial system.

Here are some of the key issues raised:

WHAT EXACTLY IS COVERED BY THE BAN?

Germany banned naked short selling of euro zone government bonds and shares in 10 leading German financial institutions, as well as transactions in credit default swaps (CDS) linked to euro government bonds. The ban took effect from midnight and will run through March 31, 2011.

Short selling is a trade that bets a price will fall. Naked short selling is when a trader sells a financial instrument without first borrowing the instrument or ensuring that it can be borrowed.

WHAT DOES THE BAN AIM TO DO?

Large short positions typically push the price of the securities lower and the ban is seen as aiming to limit pressure on euro zone peripheral economies such as Greece, Portugal and Spain.

Greece has required a 110 billion euro ($137 billion) emergency loan from the European Union and the International Monetary Fund. Yet some analysts have also voiced concern that the ban could be aimed at heading off a problem in the pipeline of which financial markets are not yet aware.

Analysts say it is unclear whether the ban will work and that it could backfire on Germany if other financial centers do not follow suit.

WHAT WILL BE THE IMPACT ON MARKET LIQUIDITY AND WHY?

Market liquidity has been affected by Berlin’s solo effort to drive away speculators as the move sparked concern other countries might introduce similar measures.

Data provider Markit said that uncertainty has created “febrile” conditions in the CDS market, resulting in low liquidity and high volatility.

Corporates and financials with peripheral exposure have underperformed markedly, “indicating that the market is becoming more wary of a peripheral sovereign default,” Markit said.

Investors tend to cut positions in riskier assets in such a high volatile market conditions.

HOW BIG IS NAKED SHORT SELLING OR SHORT SELLING IN THESE

ASSETS?

The ban will be applied to institutions operating under German securities watchdog BaFin, though it will not include branches of German firms outside the country.

Analysts and traders say the bulk of short selling is being done in New York and London, but added that it was difficult to quantify how much of it was naked.

For example, Data Explorers, which tracks the amount of stock out on loan to give an indication of how much “shorting” of a stock there is, said Commerzbank is the only stock of the 10 German financial firms subject to the ban on naked short selling where investors held a significant short position.

It said 5.1 percent of Commerzbank stock was out on loan at Monday’s close, while only 1 percent of Deutsche Bank was out on loan, and the amount on loans for all the other eight stocks was under 2 percent.

It did not specify the proportion of such trades which were naked short sales.

WHAT ARE THE CHANCES THIS WILL HEAD OFF PRESSURE ON EURO

PERIPHERAL BONDS AND SOVEREIGN CDS?

Premium investors demand to hold 10-year Greek government bonds rather than German benchmark Bunds rose on Wednesday but this trend was not necessarily expected to be sustained or driven by the ban.

The confusion in European markets, even as investors sought safe havens, saw U.S. Treasuries outperform German debt and this could turn into a more sustainable move.

The ban has also put pressure on the euro, which was viewed as a key target for betting against European assets for investors who find themselves unable to short sell bonds or equities, analysts said.

The euro fell to a fresh four-year low against the dollar, while European shares fell more than 2 percent by midday on Wednesday. Shares in most of Germany’s financial companies were weaker.

HOW SUSTAINED WILL THE MARKET REACTION BE?

In the medium to long run, the clampdown will be bad for Bunds as it takes away the ability of investors to hedge their positions through buying German government bonds and shorting bonds in other peripheral economies, according to Sean Maloney, bond strategist at Nomura.

The impact of the ban on liquidity and market conditions will also crucially depend on whether other countries -- and which ones -- take a similar line. If big financial centers, such as London and New York, have different rules, there will always be ways to circumvent the ban.

HOW CAN INVESTORS GET AROUND THE BAN?

Numerous ideas have emerged about how traders and investors could translate their negative views on the assets subject to the German ban into action without falling foul of the BaFin rules. These include:

1) Carry on shorting euro government bonds, sovereign CDS in New York and London as the ban only applies to institutions operating under German securities watchdog BaFin.

2) Buy CDS in senior German financials or indexes such as iTraxx Main.

3) Sell DAX exchange traded funds and buy non-financial German stocks, as German exporters are likely to benefit from a weaker euro.

4) Sell something else correlated to the banned instruments, such as European bank stocks

Additional reporting by Jane Merriman, William James, Emelia Sithole, Veronica Brown, Steve Slater, Alex Chambers, Blaise Robinson, Natsuko Waki and Joanne Frearson; Editing by Jason Neely

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