Gold Derivatives: Gold Derivatives: - World Gold Council

The argument that leverage induces volatility was largely endorsed by the Brady
Commission (1988) in its report on the 1987 stock market crash. Interestingly,
this conclusion was not shared by the Working Group on Financial Markets (1988),
which comprised the Secretary of the Treasury, and the Chairmen of the Securities
and Exchange Commission, the Federal Reserve Board and the Commodities
and Futures Trading Commission. The SEC Chairman concluded that raising
margins would reduce stock market volatility, while the other three members of
the working group did not believe this was supported by the evidence.
2.2 Derivative markets and shorting
A separate line of attack focuses on the way that futures markets make short selling
easier. In some spot markets short selling is either prohibited or restricted (for
example, on the New York Stock Exchange, stocks can only be sold short on an
up-tick). Even where short selling is unrestricted, the seller needs to borrow the
asset in order to deliver it to the market, and stock borrowing may be difficult or
expensive for tax or regulatory reasons. By contrast, on a forward or futures market
it is as easy to go short as to go long. Arbitrage then ensures that any selling on the
forward market is transmitted to the spot market.
It is tempting to believe that the prevention of short selling will increase prices.
For if those with the most negative views are constrained in the degree to which
they can sell, their weight in determining the market clearing price will be diminished.
But the argument is not convincing. It ignores the fact that those who
sell short must ultimately buy back if they are to realise any profits. It also assumes
that the trading behaviour of other parties is not affected by the short
selling constraint. If traders know that those who are more bearish about the price
are unable to participate in the market, they will surely treat the consensus view
of those who are participating as biased upwards.
A further argument against the view that short-selling constraints increase prices
is that the constraints would not have any effect on the income from holding the
asset. A higher price would mean that the total return (running return plus capital
growth) would be lower on constrained assets, and investors would therefore
shun them, leading prices to match those on unconstrained assets. However this
argument is less applicable to gold than to other assets because of the peculiar
nature of the return from holding gold.
There are reasons for believing that short-selling constraints may actually reduce
asset prices. They reduce participation in the market and hence reduce liquidity.
If the demand for borrowing the asset is reduced, the borrowing rate for the asset
will tend to be lower, and owners of the asset will lose income from lending the
asset. It is striking how in recent years many governments have taken measures to
make it easier to sell their bonds short. They have a strong interest in raising the
Gold Derivatives: The market impact 97