The proposed $700 billion safety net for banks and lenders hasn’t stopped the Dow from sliding over 200 points today. Neither has the SEC’s temporary ban on the short selling of 799 financial institutions.

According to Dan Denning in The Daily Reckoning Australia, the ban could actually make the crisis worse. That’s because investors could be reluctant to take up long positions in stocks when they cannot hedge their risks with short plays.

If confidence is not restored quickly, the next logical step for regulators would be to close the markets altogether…

This from Dan:

The US$700 billion Paulson plan is barely three days hold. Yet you already get the sense that it is failing in one essential objective: restoring investor confidence in the global financial system. This week, as shocking as it is to say it, could be even more momentous (and destructive) than last week.

Keep this one point in mind, we have moved beyond debates about asset valuations and whether this is a liquidity crisis or solvency crisis. This is now a test of whether ordinary investors and savers believe the financial system is on the verge of a collapse.

That’s it, plain and simple. It’s tempting to think we’ve averted the crisis and are now beyond it. Most of the time, investors ride the ups and downs in the market and go about their normal business.

But this is not most of the time. The action in the money markets last week made it clear that investors have lost nearly all confidence in the share market and in the regulators of the financial system. They are moving to cash.

If the Paulson plan fails to restore confidence, the next logical move by governments is to close markets altogether. Think about it. First, the regulators ban short selling. This squeezes the bears to cover and sends markets soaring, at least for a bit. But if it doesn’t work, the only real intervention left is to close the market altogether and take a bit of a holiday.

But for now, we’ll have to see how markets reaction. The first indications are: with indecisions. The ASX delayed its opening this morning so that ASIC could clarify its new policy on short selling to market participants. That policy changed twice over the weekend. First, ASIC joined the U.K. and the U.S. in banning naked short selling.

It didn’t stop there. Whereas the U.S. has banned short selling of any kind on financial stocks to halt the collapse in share prices, ASIC put a blanket ban on shorting of all Aussie shares, full stop. The regulator was apparently concerned that leaving open the resource shares to shorting by global hedge funds was not prudent.

The policy goal is obvious: halt falling share prices by shooting the bears in the head. The intended consequence was achieved in London on Friday, where shares were up 9%. But look out for the unintended consequences.

It’s not just bears who short sell. Hedge funds, by definition, hedge long positions by going short to cover their exposure. Remove their ability to hedge and you invalidate the logic of the trade. In other words, if hedge funds can’t go short, they might not go long either.

The result? After a huge short-covering rally, we suspect some stocks will go no bid. After all, who’s going to want to go long in this environment (especially if you can’t hedge your risk)? Markets are only markets when traders and investors are willing take up opposite views of what’s going on. This is what makes markets, the willingness to take the other side of the trade.

By eliminating short seling, the regulators insure a short-covering rally in the short term. But in the long term? They’ve actually made the market even riskier. You have one remaining choice: long only, or out of the market altogether.

We reckon a lot of people will chose to liquidate their longs and get into cash, rather than being long only at a time like this. The irony then, is that the ban on short selling may actually instigate the market meltdown it’s designed to prevent. Perverse, but perhaps true.

Institutional investors do have the alternative of hedging their longs in the options markets. Look for increased volume on put options. But this trade is rather obvious too, and the premiums on put options would be steep at this point. Again, the sensible (as well as panicked) position is the same: it is better to be out of the markets than in them.

Frankly we’re not sure what would reverse this sentiment. But it’s not our job to engineer sentiment, only to read it. Right now, confidence is on a knife’s edge. And by banning short selling, quite unintentionally, Aussie regulators may have done precisely the thing to kick off a week of full-scale liquidation in global share markets.

Source: Short Selling Ban May Kick Off Market Liquidation