Short ban seen exacerbating sharp market drop

By Jonathan Spicer

NEW YORK (Reuters) - The global crackdown on short selling has made volatile markets more erratic and may have exacerbated the recent plunge in financial stocks because of the disappearance of a key cushion: short covers.

With Monday's record drops in North America rippling into Asia and, briefly, Europe on Tuesday, the undisputed culprits were U.S. lawmakers who defeated a $700 billion (388 billion pound) financial bailout plan.

Major indexes, including the Dow Jones industrial average and Nasdaq sank fast until, and even after, the close of markets, as traders scrambled under a crush of sell orders.

A sharply lower market can usually count on some support, especially towards the end of trading, from short sellers -- who sell borrowed shares in the hope of buying them back later at a lower price -- covering their positions.

But with nearly 1,000 U.S. financial firms covered under the Securities and Exchange Commission's ban, much of that support is gone.

"We're liquidity deprived right now and that absence means we can't catch a falling knife," said Jamie Selway, managing director at New York-based institutional broker White Cap Trading. "What shorts do is add liquidity (trading activity), which drives market quality and that's defined by reduced volatility."

UK regulators temporarily banned shorts on September 18. Other countries quickly followed suit in an effort to protect financial stocks said to be targeted by short sellers as the credit crisis worsens.

There is debate whether the move worked. It has split investors from Singapore to Canada, with some applauding the measures in such delicate times, while others bemoan the government intrusion in free markets.