On short selling

2010-07-16

in Economics, Politics

Every time there is a plunge in the value of a commodity – whether it is stocks, houses, or something else – people get angry at short sellers. The idea of short selling is to bet that the price of something will fall, by selling borrowed assets in the hopes that you will be able to buy them at a lower price in the future. For instance, if there is an apple shortage going on and I think a huge shipment is coming in, I might borrow some apples, sell them for a high price, and then repay the person I borrowed them from with cheap apples, once the shipment arrives.

People see short sellers as vultures profiting off of falling prices. I don’t think this is an appropriate perspective.

For one thing, without short sellers, inappropriately inflated asset price bubbles would take longer to pop. If there is no way to bet against something like rising house prices, it seems probably that their market prices will keep climbing and climbing, far above the level that can actually be sustained. When they do eventually crash (for reasons unrelated to short selling), the consequences are likely to be more painful than if short selling had kept them more in check to start with. The Economist also makes this point:

Alas, if governments keep punishing short-sellers during busts, as Nicolas Sarkozy of France and Angela Merkel of Germany want to do, there will be fewer shorts around to temper the next boom. You can bet you won’t hear leaders complaining about speculators if there is another bubble in equities or property.

They have a point.

For another, you need to recognize that the value of assets in a bubble is a weird artificial phenomenon, not something their owners are entitled to. If you run a company with a gigantic stockmarket value, but no real prospects for profitability, you cannot legitimately complain when people finally see through you and send your stock price tanking.

Finally, the general trajectory in the prices of most things is upwards. By betting on a price drop, short sellers are taking a risk based on their confidence that they can predict where things will go in the future. In a world of generally rising prices, short selling will be a losing strategy, more often than not.

Convenient as it is to treat them as scapegoats, short sellers play a legitimate economic role. Of course, none of this makes short selling permissible in combination with exploitative activities like fraud or insider trading.

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{ 24 comments… read them below or add one }

. July 16, 2010 at 7:54 am

Short-selling
Naked fear
Regulators have yet to justify their restrictions on short sales

Jul 24th 2008

IF BANK bosses have slept at all in recent months, their dreams have probably been unhappy ones. Quite a few of them will have featured nightmarish beings known as short-sellers. These ghouls sell shares they do not own—usually borrowed stock, which they sell in the hope of buying it back at a lower price. Many of them have been betting vocally, and successfully, that bank shares will fall. Now financial regulators in both America and Britain are doing their best to make bankers’ waking and sleeping hours a little less troubled, by imposing restrictions on short-selling. They should have left bankers to toss and turn a little longer.

This month America’s Securities and Exchange Commission (SEC) banned “naked” shorting—the sale of stock that investors do not yet have in their possession—of the American-listed shares of 17 investment banks as well as of the country’s mortgage giants, Fannie Mae and Freddie Mac. Last month Britain’s Financial Services Authority (FSA) introduced a new disclosure regime for short positions in companies that are selling new shares. Both announcements bore a whiff of panic: they were made during steep falls in bank shares and the fine print was tidied up afterwards. Both were accompanied by the rattling of regulatory sabres. The FSA growled that “market abuse” could explain the “severe volatility” of shares. The SEC thundered that “false rumours can lead to a loss of confidence”. It has reportedly fired off more than 50 subpoenas, largely to hedge funds.

Spreading false rumours with the intention of manipulating share prices is to be deplored. Indeed, it is usually illegal. If either regulator has evidence that this explains the fall in banks’ share prices, they should bring the culprits to book. It may be that the SEC’s flurry of subpoenas turns up something substantial. But neither of the watchdogs has produced such evidence so far.

Byron Smith July 16, 2010 at 8:58 am

But what about naked short selling?

Tristan July 16, 2010 at 1:03 pm

“For one thing, without short sellers, inappropriately inflated asset price bubbles would take longer to pop. ”

This is one way to look at the problem. Another is to point out that without inflated price bubbles, short sellers would be out of a job, or at least, out of a quick buck. Inflated price bubbles, I think, are not a source of overall good. If these price bubbles were to say, hurt people, then short sellers are profiting off people’s misery.

i.e.:

“It starts with an apparent mystery. At the end of 2006, food prices across the world started to rise, suddenly and stratospherically. Within a year, the price of wheat had shot up by 80 percent, maize by 90 percent, and rice by 320 percent. In a global jolt of hunger, 200 million people – mostly children – couldn’t afford to get food any more, and sank into malnutrition or starvation. There were riots in over 30 countries, and at least one government was violently overthrown. Then, in spring 2008, prices just as mysteriously fell back to their previous level. Jean Ziegler, the UN Special Rapporteur on the Right to Food, called it “a silent mass murder”, entirely due to “man-made actions.”

http://johannhari.com/2010/07/02/how-goldman-sachs-gambling-on-starving-the-worlds-poor-and-won

Milan July 16, 2010 at 1:27 pm

Another is to point out that without inflated price bubbles, short sellers would be out of a job, or at least, out of a quick buck.

This is a false choice.

Bubbles will arise whether short sellers exist or not. One major point in defence of short sellers is that they reduce how inflated bubbles become, and perhaps how often they occur.

. July 16, 2010 at 1:29 pm

Naked short selling, or naked shorting, is the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame, the result is known as a “fail to deliver”. The transaction generally remains open until the shares are acquired by the seller, or the seller’s broker, allowing the trade to be settled. Naked short selling is used to anticipate a price fall, but exposes the seller to a the risk of a price rise. Naked short selling is illegal in the United States, as well as other jurisdictions.

Milan July 16, 2010 at 1:31 pm

I don’t know a great deal about naked short selling, though I understand the basic idea.

A key question would be how often naked short sellers fail to obtain the shares they have promised. If it almost never happens, then the differences between naked and covered short selling may not be terribly important.

Another question is whether naked short selling produces special opportunities for market abuse, such as collusion, insider trading, etc. If so, there may well be legitimate grounds for restricting the practice.

Tristan July 16, 2010 at 3:48 pm

“Bubbles will arise whether short sellers exist or not. One major point in defence of short sellers is that they reduce how inflated bubbles become, and perhaps how often they occur.”

Why do bubbles arise? How has this been affected by de-regulation?

Milan July 16, 2010 at 3:51 pm

In essence, bubbles arise because people expect the value of an asset or class of assets to continue to increase, and they eventually push the price at which that asset trades above the level which is justified by its underlying value. For instance, stock prices get seriously out of line with the size of dividends, and house prices get seriously out of line with the size of rent payments.

You cannot regulate away excessive optimism (though you can do sensible things like reduce leverage by making loans and mortgages more expensive and costly to get). Short selling is thus an important check against inappropriate asset valuations.

Tristan July 16, 2010 at 3:54 pm

How many market bubbles caused large scale damage to the economy between 1945 and 1970?

Basically, why keep defending a de-regulated economy if the evidence shows the more highly regulated economy of the 50s and 60s was better for everyone?

Tristan July 16, 2010 at 3:56 pm

And how can you know that short selling and naked short selling doesn’t encourage the price to drop “too far”, i.e. below the real value? And if that is the case, wouldn’t regulating short selling, i.e. making it slower and more difficult, help mitigate the over-reactive properties of the market?

Milan July 16, 2010 at 4:06 pm

You cannot expect short sellers to single-handedly ensure that asset prices are always justified by economic fundamentals. For one thing, it can be hard to know what those really are. When it comes to stocks, for instance, it is not just the size of dividends that is relevant to the appropriate price per share, but also expectations about future performance.

Saying that markets work better with short sellers is very different from saying that the presence of short sellers means markets will never under- or over-value assets.

Basically, why keep defending a de-regulated economy if the evidence shows the more highly regulated economy of the 50s and 60s was better for everyone?

What specific regulations are you proposing? Rules on how fast house/stock/asset prices can rise or fall? It seems much more sensible to regulate things like capital adequacy for banks and leverage rules for borrowers, while remaining on the lookout for monopolistic behaviour and fraud.

It can also make sense to regulate how exposed certain classes of investor are to certain assets. For instance, it is foolish for the pension funds of private firms to invest too heavily in the stock of those firms.

Byron Smith July 17, 2010 at 5:06 am

Yes, bubbles have ensued wherever complex markets have developed and are ultimately rooted in human optimism and greed. There are indeed ways of discouraging them, but they are certainly not an exclusively modern phenomenon.

Tristan July 17, 2010 at 11:22 am

Two things.

1) De-regulation, opening up things like foreign direct investment, which makes countries subject to capital flight, is largely a 70s to present phenomena. It does make the world economy less stable. And it appears that short sellers take an important place in this instability.

That said,

2) It’s stupid to “blame” short sellers as individuals. Just as it’s stupid to blame anyone in capitalism as “individuals”. People play roles markets create for them, and if they refuse to play them, they’ll be fired and someone else will do it.

The same issue appears in soviet style communism, in fact – you don’t blame the economic planners – they are probably decent people doing the best job with the conditions given to them, and if they don’t do it, someone else will. The fact that central planning of consumer goods is a lousy idea isn’t their personal fault.

Milan July 17, 2010 at 11:44 am

Foreign direct investment is a major reason why 600 million people in China have gotten out of absolute poverty since 1981.

Tristan July 17, 2010 at 11:47 am

Somewhat tangential,

A fun cartoon depiction of many different explanations of the “crisis”. Entertaining.

http://www.youtube.com/watch?v=qOP2V_np2c0&feature=player_embedded#!

. December 5, 2010 at 3:56 pm

“Institutional investors and hedge-fund bosses do not deserve the attention they are getting. They are far duller folk than their caricatures and the offences they are accused of crumble on closer examination. There is almost no evidence to connect speculators to the commodity-price spikes that they are routinely blamed for creating (see article). And what little distortion speculators may cause is soundly trumped by the service they provide. In particular, they supply liquidity and price information that makes futures markets more efficient. Speculators plug the gap when the hedging requirements of raw-material producers and buyers do not coincide, offering a counterparty for trades that might otherwise have no takers.

The suggestion that speculators deliberately manipulate markets to earn profits through bubbles and busts simply does not hold water. The explanation for the sudden spikes in the prices of many commodities in recent years lies in nothing more sinister than the laws of supply and demand. A ravenous China, underinvestment in mining and agriculture, tight markets and unexpected disruptions to production are usually to blame for rapid price movements. When supply is tight, a small increase in demand can have a disproportionately large effect on price. Even if speculators do sometimes push prices out of kilter the fundamentals soon regain the upper hand.”

. February 15, 2011 at 7:42 am

Guardian
George Monbiot
Almost everyone condemns naked short selling. But not the British Treasury

“You don’t like the idea? Then take a look at naked short selling. In this case sellers not only don’t own the assets they’re selling, they haven’t even borrowed them. They sell a promise of shares, hope the price falls, then try to obtain the shares they’ve sold. In the surreal traditions of modern finance they’re effectively selling securities that don’t yet exist (perhaps they should be called insecurities). Naked shorting may grant short sellers golden opportunities to wreck companies and economies, by flooding the market with low-cost ghosts.

“Almost everyone condemns naked (also known as uncovered) short selling and wants it banned because of the huge risks it presents to the economy. It has been prohibited in the US, Japan, Hong Kong, Australia and Brazil: none of which are renowned for draconian regulation. The European parliament has drafted a directive to bring it to an end within the EU. I did say almost everyone, didn’t I? There’s one group frantically seeking to protect naked shorting and strangle the directive: the British Treasury, and Conservative MEPs acting on its instructions.”

. October 22, 2011 at 6:15 pm

“For an airline, or an independent oil producer protecting itself against a fall in the price [of oil], or a home-heating oil distributor worrying about what would happen in the winter, someone needed to be on the other side of the trade. And who might that person be? That someone was the speculator, who had no interest in taking delivery of the physical commodity but is only interested in making a profit on the trade by, as the NYMEX puts it, “successfully anticipating price movements.” If you wanted to buy a futures contract to protect against a rising price, the speculator would in effect sell it. If you wanted to sell to protect yourself against a falling price, the speculator would buy. The speculator moved in and out of trades in search of profits, offsetting one position against another. Without the speculator, the would-be hedger cannot hedge.”

Yergin, Daniel. The Quest: Energy, Security, and the Remaking of the Modern World. p.168 (hardcover)

. October 22, 2011 at 6:19 pm

“In 2008 Mexico went all out and hedged its entire oil exports and locked in a price. It was not cheap; the cost of this insurance was $1.5 billion. But when the price plummeted, Mexico made an $8 billion profit on its hedge, thus preserving $8 billion for its budget that, without the hedge, would have otherwise disappeared. It could only have done that huge trade over the counter. If it had tried to do it on the futures market itself, the scale would have set off a scramble by other market participants before Mexico could even begin to get all of its hedges in place.”

Yergin, Daniel. The Quest: Energy, Security, and the Remaking of the Modern World. p.187 (hardcover)

Tristan October 23, 2011 at 6:29 pm

Financial independence is almost always good for countries – because they can do what is in their best interests. What we often confuse because they so often happen to be the same thing is economic imperialism with the implementation of markets. Imperial powers desire markets to be implemented in 3rd world countries when it is good for them, regardless of whether or not it is good for the 3rd world state. The problem isn’t simply markets – it’s the imposition of markets when they run counter to the interests of states. When markets are imposed through the threat of force or other forms of coersion that undermine the 3rd world state’s ability to govern, that’s imperialism.

Milan October 23, 2011 at 9:40 pm

What do you mean by ‘financial independence’?

The countries that have made the biggest strides in recent decades (evaluated through objective measures like people exiting extreme poverty) have often been those that integrated their economies with those of other countries. Japan, South Korea, and China are all examples of countries that have benefitted substantially from export-led growth.

In any event, Yergin’s point isn’t about trade – it is about the kind of financial instruments that are sometimes derided as mechanisms for powerful corporations to exploit developing countries. As the Mexican example shows, it is also possible for countries to use such financial mechanisms to reduce risks, such as those associated with having a high level of economic dependence on the export of a single commodity.

Tristan October 24, 2011 at 3:16 pm

Financial independence means foreign countries or institutions don’t dictate a countries’ economic policy. The IMF and World Bank are the most obvious forms of imperial financial and monetary control. You leant me a book which explained these things in depth. (I have the book if you’d like it returned).

Tristan October 24, 2011 at 3:23 pm

” it is also possible for countries to use such financial mechanisms to reduce risks”

It’s always possible for institutions to be used for purposes other than the ones they are created for. Tools get used for new purposes all the time.

However, it’s only possible for them to use them this way if they aren’t been leaned on to do otherwise.

. October 29, 2011 at 10:33 am

EUROPEAN politicians may not agree on much about the debt crisis but they are fairly united in their dislike of speculators. In August Belgium, France, Italy and Spain introduced bans to prevent the short-selling of financial stocks. The rules in France and Italy are likely to stay in place until November 11th; those in Belgium and Spain are indefinite. This week the European Union also agreed to ban “naked” shorting of shares (when stocks have not been borrowed before they are sold) and naked purchases of sovereign credit-default swaps (CDSs), whereby investors buy protection without owning the underlying bonds. The ban starts in November 2012.

The summer bans have not stopped shares in financial institutions from falling. According to Credit Suisse there was a brief period of outperformance in the protected shares as short-sellers reduced their positions. But as of last month they had fallen by 10.4%, compared with a 4.4% decline in German, Dutch and British members of the MSCI financials index. Liquidity in banned shares is down and bid-ask spreads are up. One hedge-fund manager says the bans sparked a “self-feeding frenzy” as investors tried to dump restricted stocks.

Critics (the British among them) worry the naked CDS ban will end up being even more damaging. Investors in assets that are correlated with the value of sovereign debt will still be allowed to hedge their exposure by buying sovereign CDSs but it is unclear to what assets that exemption applies. Some may simply exit positions in things like infrastructure and corporate debt rather than wait to find out. It may also become more difficult for sellers of protection to hedge themselves, reducing liquidity. That explains why national regulators have an option to lift the ban if they can prove it is hurting their sovereign debt.

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