The contrast could hardly be more stark. While the United States and Britain are busy banning short selling in a desperate attempt to stabilise stricken bank shares, China is pressing ahead with the introduction not only of short selling, but also of margin trading. The funny thing is that all three have got it wrong. Over the last week countless financial media pundits have described short selling as the practice of selling stocks that you don't actually have in the hope that you will drive their price down. Once they've fallen, you can buy them back again more cheaply than you sold them, which allows you to close out your position at a tidy profit. Now some people actually do this, but strictly speaking what I've described is an activity known as naked shorting, which is especially risky. Quite rightly, naked shorts have been outlawed by the US and British authorities. If a shopkeeper pretended to sell you a can of beans and pocketed your money knowing full well he had no ability actually to hand the can over, you would regard him as a fraud. There is no reason why financiers should get treated any differently. But naked shorts are not the only type of short selling. Regulators in London and Washington have also banned the far more common and valuable practice of covered shorting. This involves first borrowing the shares that you want to sell, which ensures that you are in a position to deliver the stock as required. Generally you borrow from a custodian bank, which looks after shares on behalf of their institutional owners. Usually you have to put down collateral - often more than 100 per cent of the shares' value - and you have to pay a fee for the privilege of borrowing. Now, contrary to what you may have heard over the last few weeks, covered shorting is of limited use to malicious speculators, but extremely valuable for reducing risk. It is frequently used by long-short equity portfolio managers to eliminate overall market risk. For example, one popular trade recently has been to go short HSBC stock, offsetting the trade with a long position in Standard Chartered shares. The portfolio manager doesn't care if the overall banking sector crashes, because his net exposure to banks is zero. All he is doing is betting that HSBC will underperform because of its exposure to borrowers in the US and Britain, while Standard Chartered will outperform because of its concentration on relatively healthy Asian markets. As a result, banning short sales can actually increase the risk of equity portfolios by limiting the ability of portfolio managers to neutralise market risk. The ability to sell short is also widely used by futures brokers. In a falling market, many ordinary equity fund managers will look to hedge their portfolios by taking short positions in index futures. This will tend to leave futures brokers sitting on net long positions, so they hedge the risk of their own exposure by selling stocks short. Stripped of the ability to sell short, futures brokers will be less able to do business, which in turn restricts the ability of pension funds and other investors to hedge their risk. Yet while covered short selling is handy for reducing risk, it is of limited use to malicious speculators looking to profit from driving down the prices of vulnerable stocks. That's because it can get extremely difficult to borrow target shares. If speculators are ganging up on a particular stock, the big pension fund investors that own most of the shares will simply call up their custodian bank and instruct it not to lend the stock. After all, it is the pension fund that stands to lose if the share price plummets. As a result, the fee for borrowing the stock will soar to punitive levels, effectively preventing malicious shorting. The mechanism is self-regulating. By now you are probably wondering, if short selling is such a good thing and the US and British authorities were so wrong to ban it, why it would be a bad thing for the Chinese regulators to permit it. The answer is that what is right for mature markets like the US and Britain may be wrong for developing countries like China. With the A-share prices and trading volumes down massively from last year's highs, (see the charts below) Chinese regulators are hoping the introduction of short selling and margin trading - and subsequently of futures and options - will help boost turnover and revitalise the market. They are wrong. All these new measures are likely to do in the short term - if anything - is exacerbate market volatility. Rather than introducing sophisticated new investment tools like short selling, Chinese officials would be far better off getting the market they do have to work properly. That means doing things like strengthening corporate governance, bolstering minority shareholder rights, improving transparency, cleaning up the listing process, cracking down on market abuses, raising standards of investor education and, above all, getting the government out of the business of trying to direct prices. Once they've done all that regulators will be able to think about allowing more advanced investment techniques. Until then banning short selling will remain wrong for the US and Britain, while allowing it will be equally wrong for China.