Why are Restrictions on Short Selling of Sovereign Debt Detrimental for Risk Management and Government Borrowing Costs?

Policy makers are contemplating restrictions on the shorting of government, including a ban on the (naked) short-selling of government bonds, and derivatives related to those bonds. Sovereign issuers and primary dealers have expressed their unease about the potentially adverse impact, or unintended side-effects, of some of the new financial market regulations for public debt management and the functioning of government securities markets. More specifically, they are concerned about the adverse impact, or unintended side-effects, of short-selling restriction on sovereign debt. Short selling benefits market liquidity, pricing efficiency, and enables more effective risk management. Reducing access to short selling for risk management purposes will make markets less stable, not more, and is likely to lead to higher borrowing costs for sovereigns. This article assesses the (potential) adverse consequences of short-selling restrictions for the implementation of risk management procedures and their knock-on effects on government borrowing costs. To that end, the focal point is on the explanation of the benefits of short-selling from a risk management perspective, supported by real-world examples of hedging techniques in cash and derivatives markets for government securities. The spotlight is on short-selling as a tool for risk management, while the article is in principle neutral about which (specific) financial instruments or markets should be used to implement these hedging strategies, except for references to possible problems in (the use of) sovereign CDS markets