The Theory: Mechanics & Risks
The short sale bans do not work (the top chart shows the US ban from 8/08) mainly because the underlying company fundamentals (i.e. the value of the company) do not change, but also because today’s breadth of interconnected financial products makes it almost trivially easy to develop synthetic short positions. To create such a synthetic short one would look to build an arbitrage position but simply leave a hole where the banned security would otherwise fit in the portfolio. For example the most direct way to build a synthetic short here would be to short a European financials ETF and then use the proceeds to buy up the individual components, say German, Danish, and maybe Polish financials but not those from France, Italy, Spain or Belgium. The net effect is that one has a short exposure to securities that one is not technically allowed to short. The hitch is that everyone knows this and the European financials ETF becomes hard to borrow, driving up the costs.