Short selling has been around since the birth of modern capital markets. Investopedia offers a simple definition of the concept:
"Short selling is an investment or trading strategy that speculates on the decline in a stock or other security's price."
The most common short strategy is to sell stock short, which consists of borrowing a stock, selling the stock and then buying the stock back in order to return it to the lender. Other common methods of taking a short position can be executed via the options market, such as by buying put options.
While short selling strategies can take many forms, the basic premise is the same: by taking a short position, an investor is betting against a security. Unsurprisingly, that can make short sellers unpopular.
While shorting has always had its critics, their criticism has reached a crescendo in recent months, with many leaders in the business and financial communities even calling for the practice to be banned.
A much maligned practice
The argument is hardly new. The Federal Reserve advocated for a ban on short selling during the 2008 financial crisis, asserting that a ban would "protect the integrity and quality of the securities market and strengthen investor confidence."
The Securities and Exchange Commission ended up following the Fed's advice, setting a temporary emergency ban. Other nations' financial regulators were quick to follow suit. When the next financial crisis struck as a result of the Covid-19 pandemic last year, calls came from many corners to take similar measures, though ultimately none were implemented in the United States.
Bans were implemented in a number of European and international markets where national regulators were evidently less confident than was the world's leading economic, financial and monetary power in their ability to shore up market confidence.
American inaction has failed to stymy domestic criticism, however, which has not relented even as the bull market has roared back to life. Indeed, the mayhem that engulfed GameStop Corp. (GME, Financial) earlier this year, which I discussed at length previously, was used as yet another opportunity to push for restrictions on short sellers, though such restrictions have also failed to be implemented as of yet.
Bans are not a good solution
Given the long history of attacks on short sellers, and the dark arts that are supposedly their stock-in-trade, one might ask whether a ban would actually be effective in preventing relentless downward pressure, whether it be on individual securities or whole markets. State Street Corp. (STT, Financial) provided a clear answer to this question in a study published last year, which was based on a comprehensive review of the academic literature, as well as extensive data analysis:
"When viewed holistically, empirical evidence suggests short- selling bans do not prevent declines in asset prices or reduce volatility but instead degrade market quality...In a view formed purely by empirical evidence, short-selling bans in the wake of the fallout caused by COVID-19 may do more harm than good."
Put simply, banning short selling does not result in the hoped-for reduction in downward market pressure. Rather, it actively reduces the quality of capital markets. In fact, removing short selling can have the opposite effect of what was intended. According to State Street, it amounts to adding a new market friction that reduces liquidity, which is problematic during times of crisis when liquidity is essential:
"Empirical findings...tend to agree that short- selling constraints reduce liquidity at the single-stock and broader market level. Unintended consequences of short-selling restrictions are costlier trades that are more difficult to execute."
Unpopular but necessary
Short sellers' unpopularity is hardly surprising. No one likes to hear that their cherished investments are overpriced or that management teams they trust are doing shady business behind their backs. Yet such information is critically important to the proper functioning of capital markets, especially with regard to the process of price discovery.
Short sellers are hardly without support. On Feb. 21, Hemang Desai, a distinguished professor of accounting at Southern Methodist University–Dallas, and Quinton Mathews, managing member of research firm QKM, published a rousing defense of the practice:
"Short-selling practitioners make easy scapegoats since they profit when the share prices of targeted companies go down. But this oversimplification obscures the important and positive role short sellers play in our capital markets. If anything, their actions are an important mechanism by which stocks are prevented from deviating significantly from their fundamentals...Short sellers play an important role in our society by facilitating efficient resource allocation, uncovering corporate malfeasance, and — contrary to conventional wisdom — placing a floor in stock prices when they are in free fall. They do so by identifying over-valued securities and betting (take a short position) that the price of the securities will fall. Though it may seem counterintuitive, short sellers play an important function in a capital market-based economy because the price is an important indicator of a firm's value and its prospects. Thus, the price of a firm informs the investment and resource allocation decisions of investors and corporate managers."
As I see it, market integrity and efficiency would suffer a severe blow should short selling be further restricted, or even banned. It may not be pretty, but it is important. The market needs naysayers who can point out flaws in companies and investment theses. Silencing such critics would arguably be doing all investors a disservice.
Disclosure: No positions.
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