Should short selling be banned?
Yesterday it was announced that the short selling ban in France, Italy, and Spain for financial stocks would be continued; there’s also an indefinite short selling ban in Belgium. What is this and does it make sense?
Short selling is mathematically equivalent to buying the negative of a stock. To see the actual mechanics of how it works, please look here.
Typically people at hedge funds use shorts to net out their exposure to the market as a whole: they will go long some bank stock they like and then go short another stock that they are neutral to or don’t like, with the goal of profiting on the difference of movements of the two – if the whole market goes up by some amount like 2%, it will only matter to them how much their long position outperformed their short. People also short stocks for direct negative forecasts on the stock, like when they detect fraud in accounting of the company, or otherwise think the market is overpricing the company. This is certainly a worthy reason to allow short selling: people who take the time to detect fraud should be rewarded, or otherwise said, people should be given an incentive to be skeptical.
If shorting the stock is illegal, then it generally takes longer for “price discovery” to happen; this is sort of like the way the housing market takes a long time to go down. People who bought a house at 400K simply don’t want to sell it for less, so they put it on the market for 400K even when the market has gone down and it is likely to sell for more like 350K. The result is that fewer people buy, and the market stagnates. In the past couple of years we’ve seen this happen in the housing market, although banks who have ownership of houses through foreclosures are much less quixotic about prices, which is why we’ve seen prices drop dramatically more recently.
The idea of banning short-selling is purely political. My favorite quote about it comes from Andrew Lo, an economist at M.I.T., who said, “It’s a bit like suggesting we take heart patients in the emergency room off of the heart monitor because you don’t want to make doctors and nurses anxious about the patient.” Basically, politicians don’t want the market to “panic” about bank stocks so they make it harder to bet against them. This is a way of avoiding knowing the truth. I personally don’t know good examples of the market driving down a bank’s stock when the bank is not in terrible shape, so I think even using the word “panic” is misleading.
When you suddenly introduce a short-selling ban, extra noise gets put into the market temporarily as people “cover their shorts”; overall this has a positive effect on the stocks in question, but it’s only temporary and it’s completely synthetic. There’s really nothing good about having temporary noise overwhelm the market except for the sake of the politicians being given a few extra days to try to solve problems. But that hasn’t happened.
Even though I’m totally against banning short selling, I think it’s a great idea to consider banning some other instruments. I actually go back and forth about the idea of banning credit default swaps (CDS), for example. We all know how much damage they can do (look at AIG), and they have a particularly explosive pay-off system, by design, since they are set up as insurance policies on bonds.
The ongoing crisis in Europe over debt is also partly due to the fact that the regulators don’t really know who owns CDS’s on Greek debt and how much there is out there. There are two ways to go about fixing this. First we could ban owning CDS unless you also own the underlying bond, so you are actually protecting your bond; this would stem the proliferation of CDS’s which hurt AIG so badly and which could also hurt the banks holding Greek bonds and who wrote Greek CDS protection. Alternatively, you could enforce a much more stringent system of transparency so that any regulator could go to a computer and do a search on where and how much CDS exposure (gross and net) people have in the world. I know people think this is impossibly difficult but it’s really not, and it should be happening already. What’s not acceptable is having a political and psychological stalemate because we don’t know what’s out there.
There are other instruments that definitely seem worthy of banning: synthetic over-the-counter instruments that seem created out of laziness (since the people who invented them could have approximated whatever hedge they wanted to achieve with standard exchange-traded instruments) and for the purpose of being difficult to price and to assess the risk of. Why not ban them? Why not ban things that don’t add value, that only add complexity to an already ridiculously complex system?
Why are we spending time banning things that make sense and ignoring actual opportunities to add clarity?
mathbabe 
I don’t have any kind of insightful comments, but I just wanted to thank you for posts like this… I’m learning a ton from your blog. Every time I heard the term “selling short,” it always seemed to have vaguely negative connotations, so I assumed it was a bad thing that people did to cheat the stock market somehow. It’s nice to understand a bit more about it, and to realize that I was supposed to think it’s a bad thing (but that don’t make it so).
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Thanks! That’s just what I hope to do.
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Mathbabe, as your comment in the 2nd-to-last paragraph suggests, banning short selling is also completely impractical because it is trivial to synthesize a short position using only options (http://www.theoptionsguide.com/synthetic-short-stock.aspx).
So, since professional traders can essentially ‘walk right around’ any such ban, who then is most impacted by the noise injected into the system by the ban? Why, ordinary investors of course. And as implied by one the points of your post, those who are least resilient to it, and in my opinion, least deserving.
The paradoxical conclusion that results is then the question: If we ban short selling, should we therefore also ban all short-side option trading? (of course which then implies banning all options) – assuming we want to be logically consistent.
Sounds like curing the disease by killing the patient, but I guess it works. : )
And, regarding your reasonable and well made criticisms on CDS (which I fully agree with) – unfortunately they can be synthesized too.
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There is definitely a shoot-the-messenger element to short-selling opposition. The pop in prices from a new ban and the loses that shorts are forced to take are sometimes regarded as a positive by those distressed by falling prices, but I don’t see it as having a real positive effect on the market, and it seems you agree.
I can believe there are real abuses in penny-stock land, but even there short-selling may just be the mechanism by which some other destructive activity is made profitable. (I haven’t really ever looked.)
Regarding the 2008 ban on shorting financials, some accounts say the SEC mostly concluded it had too many negatives and would not be repeated, but I’m not sure if that was just the wishy-washiness of Cox. California has also pressured the CDS market for its muni bonds, and in the past few years we’ve seen a number of European short-selling bans with various terms. All these seem pointless to me.
Even though we seem to agree on these points about short-selling, we might start to diverge on the further points you make. I have not seen very convincing arguments against CDS as an instrument, though risk management is critical there as everywhere. (I know it can turn into a huge discussion.)
Is there a real reason to worry about systemic exposure to Greek CDS? I am skeptical of the concerns raised about this on blogs (eg, Street Light) starting back in June, and I guess that regulators are getting better at assessing these exposures as in your vision. Isn’t the cash bond exposure in European banks the real concern?
Do the structures created out of laziness for the purpose of being difficult to price and risk manage actually exist? That’s a pretty cynical characterization.
OK, maybe you mean something like reverse convertibles as in this FINRA notice. http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P120883
Seems there has in fact been heightened scrutiny of these in recent years, and I agree with that and wouldn’t mind seeing things go further for retail. They just seem too susceptible to miss-selling and the problem keeps popping up.
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These kind of suggestions always make me uncomfortable, they sound like pleasant platitudes with no concrete implications or worse they might be pleasant platitudes with bad real world consequences. It is also reminiscent of the ‘Labor theory of value’, a disaster even by Marxist standards and finally ‘value’ is inherently vague and subjective.
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I agree with your suggestion about requiring holders of CDS being required to hold the bonds insured. I also think all life insurance policies should be required to pay out to the estates of the insured (since the insured person themselves are presumably deceased at that point). When you have a very large policy insuring you against someone else’s loss it gives you an incentive to kill the insured.
Even If someone does use other instruments to synthesise a side bet approximating a CDS, they should no longer be able to pretend it was insurance. (And, ideally, it would attract greater scrutiny from financial regulators).
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It’s valid to take money away from corporations who don’t deserve it / won’t put it to as good of use as others. After all, resources are finite. Capital can’t go to start-ups if it’s tied up in blue chips.
However the assumption that the market values things in line with social utility is questionable.
What’s not in question is that market panics are often bad for society. For example I’m reading Krugman’s “The Return of Depression Economics”. Second chapter he outlines how the tequila crisis 1994-95 f*cked things up for not only the Mexicans, but the Argentines (how? they’re at opposite ends of l. america) as well.
So what needs to be asked is, Does short selling induce or prevent market panics? Clearly a panic can happen just by failing to renew loans (+ the multiplier effect) or runs on banks, so short sales are not necessary for panics. Then, do shorts increase or decrease the likelihood of a panic?
Another book I’m reading, The Big Short, claims that people who *wanted* to short subprime MBS’s had a very hard time doing it. No retail investors could short subprime, and hedge funds who wanted to buy the short had to deal with a lot of dealer antics. If there had been a more liquid short side, would the financial world have collapsed?
Strong empirical evidence that short selling prevents market panics would be the most convincing argument for shorts.
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Love this post.
Was the market “panicking” when LEH or Enron traded down rapidly or was the market doing price discovery to zero after abruptly ending a long herd-mentality blind spot to the fact that the firms in question were insolvent?
Having a market without shorts is a little like old Russian-style “democracy”. You can vote for Gorbachev or you can not vote. Yes, that’s a strained analogy, but I like it anyway.
And anyone doubting the value of short sellers should read “The Big Short”, referenced by the prior poster. Very compelling, true, and well written to boot!
FoW
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1. If short-selling is so effective at detecting fraud, how did Enron, Tyco, WorldCom and co maintain their high stock prices for so long?
2. Is it fair that institutions are really the only players in the short game? (as individuals are mostly excluded) Seems a little one-sided aand unfair when bearish sentiment takes hold.
3. Why wouldn’t proponents of short selling claim that helps price discovery, keeps markets liquid? Would they say otherwise? There’s no proof that short selling achieves what they claim though, as a stock can be driven far below what it worth, which is what short sellers try to do and this is what bear markets allow these minorities to do at the expense of the long suffering majority (another reason why most people lose in the stock market racket).
4. Is it fair or ethical that institutions not only lend their clients shares to short-sellers without the knowledge of their owners (ultimately individuals), but also collect a rental fee from these same short sellers? It seems like an enormous conflict of interest as these institutions are often the same people who recommended the shares as “buys” to the client. Shouldn’t the client be receiving the rental fees if they are lent to short-sellers? After all the client is the owner.
5. There are other ways to hedge besides going short, like investing in unloved industries or markets that are at lows.
6. In a company with a large number of shares outstanding you can always find a seller if the price is right.
The claims made by Buffett, Rogers, Soros and all the other fund managers and “experts” out there that short selling keeps companies honest and maintains liquidity doesn’t hold up to scrutiny. Good reporting and sound regulatory measures do more to keep companies honest and keep investors from getting carried away than a bunch of shadowy short-selling hedge funds. If short selling were banned Soros et al wouldn’t make as much money, especially in bear markets, which all you experts know account for at least 40% of every hundred years. These guys are rich because they can short, usually with other peoples money and plenty of leverage, and you can’t.
If most of the people are excluded from playing the bear side, except for institutions that stand to make a lot of money from panicky long investors you know something doesn’t smell right. My bet is that there would be a lot less volatility and you’d rid a lot of the questionable activity and wild gyrations in stock prices if short-selling were outlawed.
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Short-selling doesn’t just “take advantage” of drops in the market — in large enough numbers, IT DELIBERATELY CONSPIRES TO CREATE THEM.
First of all, short “selling” begins with outright THEFT — the “borrowing” of stock that someone didn’t purchase in the first place, and then selling it off, in order to DRIVE DOWN THE PRICE. And then once the price is down, they buy back the stock, pocket the difference in what they sold it for versus what they just re-purchased it for, and then smile weaselishly as they know they’ve just screwed over all the people who LEGITIMATELY bought the stock low, and thereby caused its value to rise.
Short-selling is economic warfare, and of the THEFT kind.
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You will notice that shorting is only advocated by those that profit from it. It should unquestionably be closely regulated. You admit it yourself; “ban owning CFDs unless you own the underlying bond”. It is the exact same logic which must be applied to shorts. If you don’t own the shares you have no interest in the company and must leave it alone. Anything else is attempting to profit by causing others to lose money. That to most reasonable humans is theft. And as other posters have said, shorts start by borrowing a share that you don’t own and you have no authority to borrow, that is also theft.
If you notice your neighbour may be in financial difficulty, and he owes you £100, by all means ask him to repay it. But if you have no financial interest in his affairs, what sort of person would take a stake in him with the intention of making a profit and deepening the his neighbour’s plight.
When you distill this argument, only the unscrupulous would support short selling. And they would support it for the gains it generates for them.
If you can’t see that, then stop poisoning more reasonable minds.
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