Short Selling in the Public Eye

As pointed out in A Short History of Short Selling, the practice of short selling has been around for centuries. It has been banned and vilified many times, and remains a controversial topic to this day. But how reasonable is the public's ill perception of short selling? Is it really that bad, or does it serve a purpose? Should it be banned outright, or embraced? In this article we take a look at both sides of the argument.

Bear raids

A common argument against short selling is that short sellers often spread misinformation in the hope of driving down the price of shares they've shorted. Isaac Le Maire was the first person to ever sell shares short, and did so because of his animosity towards the Dutch East India Company — probably the first example of a "bear raid." Such behaviour still takes place today; however, it would be foolish to assume it's exclusive to shorts. The truth is that most share-price manipulation seeks to drive prices up. "Pump and dump" schemes are commonplace in equity markets across the globe, particularly in less-regulated ones such as the OTC markets in the USA (if you read our short reports, you'll notice a fair share of them feature OTC tickers).

Simply put, any financial practice can be abused in pursuit of ill-gotten profits — that doesn't mean the practice itself is intrinsically corrupt. In both "pump and dumps" and "bear raids," the problem isn't going long or short (money can be made either way); it's the manipulation of markets and the spreading of misinformation that results in unsubstantiated valuations, market inefficiency, and defrauded investors.

Worsening downturns

Another argument against short selling is that it can worsen stock market downturns. In 1938, during the Recession of 1937–38, the SEC put in place the uptick rule in an attempt to prop up the market — a stock couldn't be shorted if its price had just decreased. It was repealed in 2007 but brought back in 2010 as the "alternative" uptick rule, which restricts shorting a stock that has fallen more than 10% in a single day.

While additional selling can worsen a downturn, the exact same dynamic happens when markets get carried away by bullish sentiment and bubbles form. When those bubbles get big and pop, they can lead to painful adjustments — the 1929 Crash, the dotcom bubble, and the 2008 financial crisis all illustrate this. Banning short selling because it can worsen a downturn is a bit like banning the purchase of shares because it can lead to a bubble.

Profiting from others' losses

"Short sellers profit from others' misfortune" is perhaps the most-touted argument against shorts. There's something about profiting from others' losses that rubs people the wrong way. In most cases where there are winners, there are also losers, and equity markets are no different. If anything, equity markets are among the most volatile and inefficient — meaning who wins and loses often doesn't reflect the underlying reality. There's strong evidence that short sellers improve market efficiency, so even if they profit from others' losses, their participation can help mitigate unwarranted outcomes.

The efficiency argument

Market prices should reflect the underlying value of an equity so that participants can allocate capital well — which requires balanced, publicly available information. Unfortunately, that doesn't always happen. The corporate world is full of instances of management emphasising positive information while omitting negative information, since publicly listed companies have a strong incentive to keep their share price going up. In other cases, unscrupulous executives, shareholders and third parties outright lie to sell overpriced shares to ill-informed victims.

Regulators would ideally intervene whenever this happens, but they're often underfunded or inept — meaning the only practical counterweight to the bias towards positive information is a market mechanism that incentivises investors to research negative information and bring it to light. Short selling has so far proved the simplest and most effective way to do that.

Short selling may not be popular, but it is at worst a necessary evil, and at best an integral part of a healthy financial system — otherwise it would have been banned and stayed banned a very long time ago.

Next: Why You Should Learn About Short Selling.

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