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In Defense of Short-Selling
Props to Dean Baker.
Short-selling can play a very important role in the market. If informed investors recognize that a stock is over-valued they perform a valuable service by selling it short and pushing down its stock price. This can both deprive the company of capital and be a signal to other actors in the market that the company might not be as healthy as is generally believed.
The economy would have benefited enormously if large numbers of traders had shorted Fannie and Freddie 4 years ago when they were buying up hundreds of billions of mortgages issued to buyers who bought homes at bubble-inflated prices. This would have stopped the bubble years ago. Similarly, we could have prevented the financial chaos at Merrill Lynch, Citigroup, Bear Stearns and the rest, if traders had recognized their financial shenanigans and aggressively shorted their stock. In the same vein, heavy shorting by informed investors could have prevented the boom and bust of the tech bubble.
The decision to intervene against short-selling is completely inconsistent with the belief in the wisdom of the markets. Of course short-sellers can be wrong and depress stock prices more than is justified by fundamentals, but so what? The government doesn't intervene when it thinks investors have exaggerated the true value of a stock. The public has no more reason to fear under-valued stock prices than over-valued stock prices. This one-sided intervention by SEC is hard to justify on any grounds.
Posted by Alex Tabarrok on July 18, 2008 at 07:10 AM in Economics | Permalink
Comments
Baker's post largely misses the point. The issue that the SEC is addressing isn't short selling in general, it's naked short selling, which is harder to defend.
In regular short selling, people borrow a stock, and then sell it. In naked short selling, they just sell it without borrowing it first. Does it make sense for people to sell something they don't actually hold? I don't think so.
I made money betting against housing and subprime mortgage stocks in 2006 and 2007, so I'm certainly not against short selling in general.
Posted by: Mitch at Jul 18, 2008 7:36:29 AM
Okay, I see the short vs. naked short distinction. For me, that boils down to a property rights issue and it was probably a good thing that SEC already was prohibiting naked shorts. But why single out the stocks of these 19 financial institutions? What smells bad here is when a significant wall street law firm (Wachtell) urged SEC to change its naked short rules and it did so (causation is neither implied nor necessary). Now today you have seven options exchange firms (market makers who take the opposite side) lobbying SEC for exemptions from the naked short enforcement. These are significant steps toward a rent seeking society, away from a free capital market.
Posted by: Ed Lopez at Jul 18, 2008 8:16:34 AM
I don't believe the goernment should control the free marketplace.........short-selling is good for the markets and the SEC should not single out a few institutions.
Posted by: Vectorpedia at Jul 18, 2008 8:35:37 AM
Does it make sense for people to sell something they don't actually hold? I don't think so.
That sounds similar to the arguments made against commodity speculators who don't take physical delivery. "Why should they buy something they don't use?" Not a perfect analogy, but somewhat fitting. I'd say naked short selling is harder to defend than regular, but defensible nonetheless. Borrowing the stock from another person creates somewhat of a barrier, akin to margin requirements in commodity speculation, for example.
Posted by: katiet at Jul 18, 2008 8:50:18 AM
I just posted the following on Cafe Hayek in response to a question about this new rule. Given the comments on this thread, I'm reposting it here. It's long.
Naked shorting is not illegal for market makers, including specialists. They are not required to locate, let alone possess the shares. This exemption is permitted because market makers and specialists are required by SEC rules to provide liquidity.
Everyone else, (who is also providing liquidity by participating, btw) is required to "locate" shares before selling them short. The actual contract to borrow the shares is executed by the broker after the brokerage client executes the short sale. A "locate" basically means that the broker has taken a look at how many shares are available to borrow and allows the client to short the amount it thinks it can reasonably borrow on the clients' behalf. THAT is the current SEC rule. Shorting without locating first is illegal.
On occasion, some of the shares disappear from the borrow market after the client has shorted but before the locate desk at the brokerage is able to secure the borrow. That results in some accidental naked shorting and the brokerage has some number of days to locate the stock before buying in the client. Usually, they're able to borrow the "naked" shares within that period of time. If not, the client has to be bought in. The rules are more complicated than that, but I'm a trader, not a locate specialist, so I don't know them all.
The change in the rule will force the locate desk to actually borrow the shares before allowing the client to short. Now, if the broker locates, and the client doesn't actually short (which happens all the time), the shares remain unborrowed and the clock on the interest is never turned on. Since the lender collects interest on the borrowed shares and the borrower pays interest, if the shares are borrowed before a trade is executed, that clock starts running whether or not there's a trade.
Further complicating the situation is dividends. The short seller owes the owner of the stock any dividends that are paid on the stock. If the trader borrows the stock, but never executes a trade, he will still owe the dividend if he has secured a borrow in case he needs to short.
You can see the inefficiencies this will create - especially if a trader trades hundreds of stocks and has to borrow and release for every stock every day. It will become more expensive to short(in all ways cost is calculated, including time). It throws sand in the gears of the market and prevents efficiency by reducing liquidity. This will be especially true for traders who engage in market making activities but are not registered market makers (there are tax disadvantages to being a registered market maker in stock vs. derivatives). Given the added expense, these market participants won't bother if the short is too expensive. Those stocks will experience lower trading volume and more price volatility.
It has been pointed out that you can short via put options (as one example). However, there are some (usually very small, illiquid and RETAIL driven) stocks for which no options trade and for which shares are already hard and costly to borrow. Those stocks, already illiquid, will see further reductions in liquidity and even more erratic price moves. In those stocks, I've seen the specialist (who doesn't have to locate) sell shares as high as 12% above the previous print just because there are no competing offers. So, that market buy order sent in by some hapless retail guy just cost him 12% plus commission. This is exactly the opposite of a liquid, efficient market.
For stocks for which options do trade, expect to pay a much higher premium for the puts to reflect the added demand. But borrowing shares will be even more expensive, so expect short sellers to simply buy puts instead of locating stock and shorting it outright. Those market makers selling the puts have to sell the underlying stock to hedge their short put position. They can sell shares naked. So, the naked short selling will actually increase instead of decrease! If the borrow or even locate rule is extended to market makers, they won't be able to hedge their short put positions and the cost of puts will skyrocket to the point that it won't be worth buying them at all. No negative sentiment will be allowed to be reflected in the market.
The prohibition on naked shorting is arbitrary and the fact that naked shorting has in the past been used to manipulate stock price is used as an excuse to make it illegal - with exceptions, of course. The SEC really doesn't care about the occasional few naked shorts that result from an honest attempt to locate and borrow the stock or from the liquidity providing activities of market makers. After all, the only reason the SEC cares about naked shorts is market manipulation and a couple thousand naked shares which the client either buys back himself or are borrowed on the client's behalf in a few days are clearly not market manipulation. The benefits of liquidity that short selling provides far outweighs any perceived risk of manipulation resulting from a few accidental naked shorts. Keeping in mind, of course, that because market makers and specialists can short naked all day long, unless there's a huge and rising naked short interest it's highly unlikely that there's market manipulation.
Incidentally, there was no increase in naked short positions in the financial stocks at the time the SEC announced this "emergency action". It's all BS. The move was, according to Chris Cox, "prophylactic". In other words, the move was intended to prop up financial firms' stock prices. And it did - especially because hearing it on TV instead of directly from the SEC threw everybody into a state of uncertainty. You really really don't want to run afoul of the SEC. Shorts immediately began to buy back shares lest some of them had not yet been actually borrowed, creating fake demand for the stocks. This resulted in a fictional run-up in the price of financial firms and the share prices clearly no longer reflected the market's opinion of fair value for them. So, the SEC executed exactly the kind of market manipulation for which you and I would rot in jail if we so much as thought about attempting it. It was a price control.
Posted by: Methinks at Jul 18, 2008 9:07:44 AM
For me, that boils down to a property rights issue and it was probably a good thing that SEC already was prohibiting naked shorts.
There are no property rights violated in naked short sales. The possibility of market manipulation, not property rights, is the reason the SEC uses to prohibit naked short selling. Just as the increased incentive to murder is used to prohibit organ sales.
Posted by: Methinks at Jul 18, 2008 9:12:06 AM
I'd say naked short selling is harder to defend than regular, but defensible nonetheless.
Short selling provides liquidity and reduces the probability of asset bubbles by keeping prices from getting to far above fair value. It can also signal problems withing the company. Short selling does far more good than harm and it would be extremely difficult to execute a market manipulation strategy even with naked shorts. The prohibition on naked shorting only decreases market liquidity and render prices less meaningful. Note what happened immediately after the rule change was announced and to stocks which are hard to borrow.
Borrowing the stock from another person creates somewhat of a barrier, akin to margin requirements in commodity speculation, for example.
Borrowing before the short is executed creates a barrier much greater and costlier than trading on margin.
Posted by: Methinks at Jul 18, 2008 9:18:33 AM
Naked short selling is essentially the same as gambling on NFL games. Unlike NFL gambling, though, the activity of short selling signals earlier to real stockholders when a company may be overvalued or undervalued. Naked shorts use their lower transaction costs to adjust the value of the company earlier than stockholders.
"Just as the increased incentive to murder is used to prohibit organ sales. "
???
Posted by: MW at Jul 18, 2008 9:27:18 AM
"Short selling does far more good than harm and it would be extremely difficult to execute a market manipulation strategy even with naked shorts. The prohibition on naked shorting only decreases market liquidity and render prices less meaningful."
Then maybe they should let everybody do naked short selling.
Posted by: J Thomas at Jul 18, 2008 9:37:17 AM
"Just as the increased incentive to murder is used to prohibit organ sales. "
??? - MW
Yes, it's one of the stupid reasons I've heard. It's not the only one, but it's the one that was most analogous to the argument against short selling.
Then maybe they should let everybody do naked short selling. - J Thomas
This requires a deeper discussion because naked short selling creates "phantom shares" (shares in excess of the number issued by companies) and it can sometimes become an issue in proxy votes. But I think that problem can be solved. Naked short selling creates no issue for the buyer of the "phantom shares" outside of proxy votes. So, personally, I think that the benefits definitely outweigh the costs and I'm in favour of letting everyone sell naked. Naked short selling will especially benefit liquidity in those very illiquid, hard to borrow shares which have a primarily retail following. The specialist won't be able to take advantage of market orders if there are others who can readily provide liquidity. It'll essentially break the specialists' monopoly and that, IMO, is a good thing.
Posted by: Methinks at Jul 18, 2008 10:24:36 AM
Does naked short selling create a dilutive effect for non-naked (covered?) shorts?
Also, one way to bust all of this up is for shareholders to hold their certificates.
Posted by: meter at Jul 18, 2008 10:27:36 AM
Does naked short selling create a dilutive effect for non-naked (covered?)shorts?
No. I'm not even sure how that would be possible.
Also, one way to bust all of this up is for shareholders to hold their certificates.
You can do that but your broker will charge you for it because it's more costly than holding your stock in street name. You have to ask if the additional expense is worth sucking a little more liquidity out of the market so that the specialist can rape you on a buy order. Seems like a poor trade-off to me.
I'm not sure about this, but I think that if you don't have a margin account, your shares can't be lent out. If you do trade in a margin account, part of the agreement you sign allows your shares to be lent out. All professional accounts are margin accounts, so a retail guy paying the price of keeping paper certificates isn't going to make a big difference in the number of shares available.
Posted by: Methinks at Jul 18, 2008 10:53:52 AM
Also, one way to bust all of this up is for shareholders to hold their certificates.
No need to do that. Instead, just call up your broker and tell him to journal the shares to the cash side of your account. They remain in street name but cannot be lent out anymore (and of course don't contribute to margin buying power or withdrawable cash anymore).
Posted by: QM at Jul 18, 2008 11:37:44 AM
there are some (usually very small, illiquid and RETAIL driven) stocks for which no options trade
I would go further and say that the options market for the large majority of stocks is basically non-existent. For really large, well-known companies with billions of dollars in market cap, there is an active options market (e.g. Wal-mart, Norfolk Southern, Goldman-Sachs). Drop down a tier to companies that are 'only' worth a few billion (Kennametal, Waters Corp, Canadian-Pacific Railway) and only a handful of options trade, with large bid-ask spreads. Drop again to see stocks for companies worth less than a billion and it gets even worse. For most companies with market cap less than $500 million or so there is no options market.
Since the median market cap for stocks in the Russell 3000 index (that's the 3000 biggest stocks) is only about $800 million, I'd guess that trading options is only realistic for the biggest 1000 or so companies.
Posted by: bbartlog at Jul 18, 2008 12:03:38 PM
Also, one way to bust all of this up is for shareholders to hold their certificates.
Yes, but the point of this whole discussion is that this measure has no effect if someone is allowed to do a naked short: they can sell what they don't have just on the basis of their promise to make good on it later. If naked shorts are disallowed, then yes, refusing to loan out your shares for sale could make a difference.
Posted by: bbartlog at Jul 18, 2008 12:10:04 PM
Borrowing the stock from another person creates somewhat of a barrier, akin to margin requirements in commodity speculation, for example.
Borrowing before the short is executed creates a barrier much greater and costlier than trading on margin.
Let me try that again.
Proposals to block naked short selling are akin to proposals to boost spec trading margin requirements to 50 or 100%.
Posted by: katiet at Jul 18, 2008 12:12:16 PM
I get it, Katie. Maybe I should have had my coffee before I answered you :)
Actually, maybe I shouldn't be worrying about all this BS on vacation either. The point is to get away, right? But my taking a vacation is apparently as pointless as short sale restrictions and government bailouts.
Posted by: Methinks at Jul 18, 2008 12:27:12 PM
Me thanks methinks for providing excellent comments on vacation time!
Posted by: Alex Tabarrok at Jul 18, 2008 12:52:27 PM
FYI, Culp and Heaton provide a nice primer on this issue for those who want to follow up:
http://www.cato.org/pubs/regulation/regv31n1/v31n1-6.pdf
Posted by: Alex Tabarrok at Jul 18, 2008 12:54:00 PM
Good link, Alex. But let me step back and be a moron for a moment. (Some critics may accuse me of persisting much longer in this condition.)
What the heck does it even mean to sell a stock that's not in your possession? Isn't somebody buying it when you short it? So let's say I short a stock at $50 but it is accidentally naked. That means somebody else thinks he has bought the stock for $50, right?
So is the idea just that this trade goes on the books, and then my broker has to go out and get his hands on the stock (by borrowing it from somebody) and then transfer ownership to the buyer, after the fact?
So are all we really talking about here, is a matter of timing?
Posted by: Bob Murphy at Jul 18, 2008 1:08:01 PM
Isn't naked short selling merely a form of futures? There is definitely nothing wrong with shorting a futures contract.
With this in mind, I don't see the economic argumaent against naked short selling. On the contrary, the prohibition of naked short selling means I have to borrow from someone, and this is economically inefficient (to say the least), especially when shares aren't widely held in street name.
The only issue I can see is voting proxies, which is my sole issue with naked short selling. I've never been able to wrap my mind around that problem.
As a general rule, whenever you hear someone whining about naked short selling, the people whining are really opposed to short selling, or alternatively are merely looking for a scapegoat for their own shortcomings (think executives who blew it).
In the long run, stocks will gravitate towards "intrinsic value", i.e. the present value of all future dividends. Anything that tends to move stocks (or any other asset) closer to that intrinsic value, be it up or down in price, is a good thing for the economy.
Posted by: happyjuggler0 at Jul 18, 2008 1:28:52 PM
Agree with Mr. Tabarrok - great comments by mt.
Posted by: meter at Jul 18, 2008 1:31:07 PM
I don't pretend to understand the pros and cons of short selling, but the Baker's argument doesn't make any sense to me.
You mean, if short selling had occurred 4 years ago, then it would provide a rationale for short selling today, but since it didn't happen 4 years ago, but should have, it would be wrong to prohibit short selling now?
Posted by: Phil at Jul 18, 2008 2:14:48 PM
Thank you Alex and Meter. It's always hard to remain on vacation when the government springs into action to solve the unsolvable.
According to the update I just got from a securities lawyer, this action represents a strict enforcement of an existing rule. I was mistaken in saying that this is a rule change. The reason the SEC enforced the rule as "locate" instead of "borrow" is because of the issues I (and many others) brought up - the rule as written reduces liquidity by raising the cost of borrowing. Even the SEC realizes liquidity is good and naked shorts are not stock manipulations. BTW, the lawyer also told me that there's a lot of concern among broker dealers. Everyone is confused and worried. Fear and confusion among market participants is going to do WONDERS for restoring confidence in the American financial system.
Oh, and there's talk of just moving some trading off U.S. stock exchanges altogether, depending on how this all plays out.
Posted by: Methinks at Jul 18, 2008 2:18:11 PM
Happyjuggler,
Bullseye! Fabulous post. Thank you for pointing out that naked shorting is merely a form of future! IMO, you smashed the
The proxy vote requires a long theoretical discussion that could completely hijack this thread. It's a
discussion nobody is having because it has been determined by popular vote that shorting of any kind is an unamerican activity, treasonous by nature and should be punishable by death. It sounds like hyperbole, but the attitude is really that venomous.
Prices should only go up. Unless it's oil. Then, prices should only go down. If you disturb this vision of the world, you are obviously a market manipulator who would sacrifice the greater good at the alter of your greed. One trader put it succinctly: "We can't buy oil and we can't sell financials."
Posted by: Methinks at Jul 18, 2008 2:28:18 PM
