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Lessons from history VI – For and against short selling

In September 2008, amidst the worst weeks of the financial crisis, regulators throughout the world decided temporarily to ban short selling. Short selling is a strategy where traders profit from losses in the value of a financial asset. If you think that the value of an asset is going to decrease, you sell the asset. In order to deliver the asset to the buyer, you simply borrow it on the market. Later, you buy the asset to return it to the borrower. If the value has decreased, you made a profit. The word “short” comes from the fact that the trader is selling something that he does not own. In a nutshell, short selling involves selling a security one does not own and replacing it with one bought at a later date to benefit from a fall in price.

A harmless yet dangerous technique, or the ambiguities of regulators

Short selling has existed for centuries. It is a basic commercial trick, which is also common in many sectors of the economy. For example, wine brokers sometimes sell bottles that they do not own, and buy them later to meet their deliveries. Usually, this is just a way to manage inventories. The reality of short selling in finance is that traders expect the price of the product to fall; it has nothing to do with inventories.

Regulators are perfectly aware of how common short selling is. In a 2009 consultation paper, the UK regulator Financial Service Authority (FSA) explained that: “We have consistently made it clear that we regard short selling as a legitimate investment technique in normal market conditions. […] Short selling can enhance the efficiency of the price formation process by allowing investors with negative information, who do not hold stock, to trade on their information. It can also enhance liquidity by increasing the number of potential sellers in the market.”

But the FSA added that: “However, especially in turbulent markets, short selling can have negative impacts, both inadvertently and through wilful misconduct. Information asymmetries (where one party has more information than another) can lead to three potential problems associated with short selling: market abuse; disorderly markets; and transparency deficiencies”. This is a good summary of the consensus among European regulators: there is nothing wrong with short selling, except when markets are turbulent, in which case temporary bans on short selling should be implemented.

This raises many questions: how can a harmless product suddenly become dangerous? What is a turbulent market? Is it not when markets are most fluctuant that short selling makes the most sense? You will not find the answers in this article, but what I would like to do is show that the debate has taken place before in financial history and the arguments are much the same.

Before the people of the United States for judgment

Short selling has been banned by many monarchs in early European financial markets. But a much more serious threat developed after the Black Thursday crash of 1929. Markets already looked a lot like contemporary exchanges, and American authorities truly contemplated the idea of banning short sales.

In that context, Richard Whitney, President of the New York Stock Exchange, delivered a series of speeches to defend the virtues of short selling. Against him, an attorney, William R. Perkins, advocated the ban. The debate, three speeches by Whitney and the three replies by Perkins, was published in 1932. The book opens with a thundering foreword: “Short selling is before the people of the United States for judgment”.

Short-selling advocate Whitney starts with an important point: “the decline in security prices has not been due to short selling but has been due to our unsatisfactory business conditions and to the liquidation of securities owned outright or held on margin”. Indeed, intense short selling is a symptom, and not a cause of pessimism. However, no one pretends that short selling explains each and every price variation on the market. But the question is the extent to which short selling artificially amplifies price movements, to the sole benefit of speculators.

Increased efficiency or risks of manipulation?

Whitney goes on to argue that short selling has a stabilizing effect on prices: “This is especially true in times of crisis when other people hesitate to buy and the short sellers represent the purchasing power which prevents the market from being demoralized”. So despite the beliefs of European regulators, short selling would be most useful… in times of crisis. Indeed, short sellers, as most speculators, often bet against the prevailing tendency on the market, a strategy which is also called contrarian investing

In the language of today’s financial industry lobbyists, short selling improves market efficiency and by increasing liquidity contributes to finding a balance on the market and reaching the appropriate price. For example, the European Banking Federation, the main professional association of the industry, wrote in a response to a consultation by the European Commission in 2010 that short selling has many “positive effects. Notably, it increases liquidity. Related to this, markets adjust quicker to new information”. After the series of bans in 2008, banks were prompt to react and they published countless research papers claiming that bans were ineffective, if not counterproductive.

The liquidity argument has been a useful tool for advocates of short selling, although it has not always been used correctly. In the case of so-called “naked use of sovereign CDS” in 2009, traders were using credit default swaps, derivatives that pay out if a bond issuer defaults, to speculate that Eurozone sovereign bonds would lose value. The more the bonds fell, the more the CDS rose, even for traders who did not own the bonds. In this case, short selling had nothing to do with contrarian investing. On the contrary, it aimed at amplifying the sovereign debt crisis to make a benefit on CDS trades. Claims that this “naked” use of CDS would increase liquidity and so reduce the issuing costs of Eurozone states were debunked in a 2011 technical paper by Finance Watch. The ban remains in place, although it has since been weakened by loopholes. If you are interested in the debate, you might want to take a look at Finance Watch’s dossier dedicated to short selling and naked CDS on this link.

But let’s go back to the book. Whitney also argued, unconvincingly, that short selling has nothing to do with “bear raiding”, defined as selling securities for the purpose of demoralizing the market. He claims that no investor holds a significant share of the market, so the risk of bear raiding is very low. But this obviously neglects implicit or explicit coordination, and the focus on vulnerable stocks. As shown by Perkins, this flaw was immediately pinpointed by The New York Times, on October 18, 1931, in its review of the debate.

The risks of market manipulations that are mentioned by the FSA are also accounted for by Perkins, who wrote with a flourish that the: “temptation [of short selling] brings those vague forebodings and mysterious rumors which undermine our psychology and sap our initiative”. Now as then, such effects are a major source of concern but remain extremely difficult to quantify and regulate.

A matter of principle

Underneath the technical debate, there are obviously political considerations. The background is the legitimacy of regulation itself. Whitney admits that he strongly believes in the virtues of laisser-faire; and that therefore “the defense of short selling is not a matter of opinion, it is a matter of principle”.

It would be too long to quote the economic press of 2008, but those who have followed the debates on short sales will be struck by the similarities with the Whitney/Perkins debate of 1931-32. We can be sure that the same arguments will crop up again and again, as they have been doing since 1929.

Fortunately, financial history is not just about figures and technicalities. It also bears its share of human tragedies: Richard Whitney, whose brother George was a very senior officer at JP Morgan, made a name for himself on October 25, 1929, when he made a bid on US Steel stock to stabilize the market, the day after Black Thursday’s crash. The bid contributed to prevent the crash from being even worse. One has to acknowledge that Richard was brave enough to materialize his theories into real behavior and significant financial risks. But the hero of 1929 was eventually caught up by his misdemeanors: he was sentenced for embezzlement in 1938, and spent three years in Sing Sing prison. I guess for the judge too, this was a matter of principle.

Fabien Hassan

References:

Richard Whitney & William R. Perkins, Short Selling – For and Against, D. Appleton and Company, New York and London, 1932.

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