A Short History of Short Selling

Dark beginnings

Short selling has been around for nearly half a millennium — a product of the financial ingenuity of the Dutch, who also gave the world unit trusts, options and debt-equity swaps. Unfortunately, its origin is more malicious than we'd like to admit.

During the 16th and 17th centuries, the Dutch Republic underwent a major economic expansion, bringing with it burgeoning international trade, a stock exchange, and the Dutch East India Company (the VOC), founded in 1602. One of the Company's largest shareholders was Isaac Le Maire — entrepreneur, investor, and likely the inventor of short selling. In 1605, Le Maire was forced out of the VOC over malpractice, beginning his lifelong animosity toward it. In 1609, in an attempt to undermine the Company, he set up a secret entity whose sole purpose was to trade VOC shares: Le Maire lent it his own 25% stake, which it sold to drive the price down.

It didn't go as planned. Despite the Amsterdam bourse attributing the VOC's declining share price to poor business conditions, the Dutch government banned the sale of shares not in one's possession — short selling's first appearance was a short-lived and notorious one. The ban was lifted two years later.

Late 18th and early 19th century

The USA government banned short selling shortly after it started, in 1812, when the New York Stock Exchange was still small enough that the ban had little impact. It was lifted in the late 1850s, and practiced by financiers such as the controversial Daniel Drew, Bernard Baruch (later a government advisor to Wilson and FDR), and the legendary Jesse Livermore.

The 1920s saw the greatest stock market expansion of all time — the result of an overvalued, overbought, ridiculously bullish market with little relation to economic reality. The bigger they are, the harder they fall, and the 1929 Crash was a hard fall indeed. Short selling was quickly blamed and banned. Abuses by unscrupulous individuals like Albert Wiggin — who shorted tens of thousands of shares of his own bank, Chase National Bank, exacerbating the Crash — fit the narrative perfectly.

In reality, short selling wasn't as widely practiced in the 1920s as it had been in the latter half of the 19th century; if it had been, the decade's excessive bullishness might have been tempered and the bubble smaller. Regardless, President Hoover launched a Senate investigation, and Congress passed the securities regulations that created the SEC and gave it wide power to regulate — and soon ban — short selling.

There's strong evidence the ban wasn't justified. In November 1932, NYSE economist Edward Meeker published a book, Short Selling, showing that only around one-hundredth of one percent of NYSE-listed shares had been sold short, and a 1931 study found short interest at 3/5 of one percent of total market value — more than ten times as many shares were held on margin.

Modern days

Since the 1930s, short selling has gone through its ups and downs. It faced near-extinction in the early 1990s, but in recent years it has carved out a place in the public eye through an increasing number of activist short sellers — starting with reports exposing several US-listed Chinese companies as scams in the early 2010s. Prominent activist short sellers include Utopia Capital Research, Citron Research, Muddy Waters Research, Kerrisdale Capital and Hindenburg Research, among others.

Some denounce these activists as fabricators attacking fairly valued companies; others see them as the democratisation of research — the closest thing to a Wall Street grassroots movement. Whether we like it or not, short selling is here to stay.

Next: Short Selling in the Public Eye.

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