Four Praises and a Funeral: In Defence of Short Selling

Everyone loves a good underdog story in which an unlikely hero takes on a mighty foe in the face of overwhelming odds. The recent US stock market uprising involving the mobilisation of retail investors to collectively drive up the share price of GameStop, a video-game retailer best known for its bricks and mortar stores, can be seen as a well-deserved and long-overdue one in the eye for unscrupulous and greedy hedge funds and their dreaded short-selling strategy. Depending on how you look at it, it could also be a possibly illegal attempt at co-ordinated market manipulation. The result is the same, though: the common practice of short-selling by hedge funds was thwarted by netizens, using Reddit’s r/wallstreetbets message board and Twitter, to band together and purchase GameStop shares, leading the share price to rise, thereby foiling the short-selling strategy and beating Wall Street at its own game.

What is Short Selling?

Short sellers have been the bogeyman of financial markets for quite some time. In fact, short selling is almost as old as the stock market itself. The world’s first stock market is arguably the Amsterdam Stock Exchange, which started operating in 1602, and already included a lively business in derivatives, such as options and repos. The first short sale occurred in 1609, when a group of investors led by Dutch businessman Isaac Le Maire shorted the stock of the Dutch East India Company. While the Dutch authorities forbade the practice following a market crash in 1610, a new trading strategy had been born and the practice of short selling has persisted for more than 400 years.

At the most fundamental level, markets would not function without a difference of opinion. For every investor that deems an asset’s value to be undervalued, such that he or she expects the price to rise to some higher fundamental or equilibrium value in the future, there must be an investor who thinks the asset is overvalued, such that the price can be expected to fall towards equilibrium going forward. If all investors were on the same side of the trade, no trading would ever occur.

Short sellers make money by betting asset prices will fall. Crucially, when they enter into the trading agreement with the counterparty, they (i) agree to deliver an asset in future while (ii) not physically possessing or holding the underlying asset. The asset is therefore borrowed from a broker and sold for delivery in the future. In other words, they are selling an asset that they do not own today at an agreed-upon price in the future. In technical parlance, they are short the asset and therefore undertake a short sale. The trade works if the price of the asset falls. At the agreed-upon future date when the underlying asset needs to be delivered, they buy the asset in the market at the now lower current price and sell it at the – higher – price agreed upon when both seller and buyer entered into the agreement. The difference in prices between those two points in time is the gain of the short-sell strategy.

Because a short seller must borrow the shares before he can sell them, this strategy is not without risks. One, there are costs associated with this borrowing. In general, the free float of ‘borrowable’ shares is often limited, such that the rental cost can be considerable. Two, should the shares increase in value over the lifetime of the short sell strategy, a short squeeze may occur. In this case, holders of short positions must buy more shares to limit significant losses, which pushes the stock price even higher, creating a form of feedback loop.

Short selling is a textbook trading strategy and comes in two varieties. Most shorting is done by hedge funds and institutional investors who want to hedge against falling share prices or to bet that share prices have risen too high. The (small) remainder attracting the most opprobrium are activist shorts, which have been the target of Reddit’s r/wallstreetbets message board campaign. These are hedge funds that do a sizeable amount of research to identify firms that have either underperformed the market or might be cooking the books or fleecing their company. While they may be ‘factually right’, these activist funds then spread the word, sometime anonymously, and hope that the firms’ share prices slump as a result.

Short Sellers in Theory: What Are They Good For?

In the eyes of their detractors, short sellers are ruthless and unethical profiteers, benefitting from – and in the process impounding – corporate woes to the point of ruin. On the other hand, they are playing a vital role in ensuring market efficiency and facilitating the price discovery mechanism of financial markets. Advocates of short selling include not only hedge funds themselves but also some well-known investors, including Warren Buffett.

In general, contrarian investors are valuable, even when they are wrong. Above all, they widen the scope for debate, which can have one of two effects. One, they encourage those with opposing views to scrutinise their own convictions and thus their trading positions. On the other hand, having considered – and subsequently dismissed – the contrarian view, they can fortify the consensus view.

Short sellers are yet another clog in the price formation and discovery process. The role of short seller lies in enhancing market efficiency and guiding the price discovery process of markets. They do this in four different ways.

To begin with, they police markets and improve transparency by probing corporate performance and seeking out cases of outright corporate malfeasance and fraud, dubious accounting practices, misguided business plans or simple mismanagement. On many occasions, short sellers spotted corporate fraud before auditors, investigative journalists, investment banks and, it cannot be stressed enough, regulators did. Indeed, they have played a major part in exposing many of the major market frauds in recent history, such as Enron (2001), Tyco (2002), the US housing market (2008) (spawning the The Big Short movie of 2015, where they were portrayed as the good guys), Lehman Brothers (2008), Luckin’ Coffee (2020), Wirecard (2020) and Nikola (2020). In so doing, short sellers and their research uncover potentially missing information in markets.

Second, efficient markets rely on the premise that market participants possess all available information about the issuer of an asset to correctly price it. In that case, the price of the stock should equal the best possible guess of its fundamental or equilibrium value. Through their activities, short sellers improve the efficiency of asset pricing by keeping share values in line with fundamentals. In the absence of short sellers, it might be hard to correct overvaluation, which is especially the case for asset overpricing. The Noahpinion blog from 2 February, for example, provides an insightful illustration of how short sellers (in the guise of ‘smart’ money) – and short sellers only – can bring about a correction in overvalued share prices due to the investment behaviour of ‘dumb’ money.

Moreover, many banks are increasingly unable to perform their traditional roles as liquidity providers and market makers in certain security types due to regulatory changes since the Great Financial Crisis. Hedge funds and other non-bank institutions are stepping forward as alternative market makers, which has the effect of enhancing market liquidity.

Finally, short sellers improve the allocation of capital in the economy. Jordà et al. (2020) have recently illustrated how insufficient liquidations impede the resolution of corporate financial distress and make it more likely that corporate zombies persist. Despite being technically not viable, these firms drain capital from more deserving projects. Successful short sellers are one way of putting these firms out of their misery and divert capital to more productive uses.

Short Sellers in Practice: How Important Are They Really?

The empirical evidence on the role of short sellers, which has recently been reviewed by Jiang et al. (2020), shows that, overall, stock prices respond more sluggishly to news and other shocks under short selling bans, meaning that short selling affects the change of stock prices more than their level. When translated to short sellers in general, short sellers do not affect the overall level of stock prices much, but they help prices change faster when fundamentals change, again making markets more efficient. Finally, short-selling bans do not have a major effect and are usually ineffective in decreasing market volatility.

Moreover, the simple existence of short positions does not cause the market price to fall, and the build-up in short positions does not automatically translate into a sell-off. As a contrarian investment strategy, short sale positions – which are based on an expectation of falling prices – are much smaller than the long positions on the other side that predict prices will continue to rise. Rather than short sellers, it is long sellers losing faith in the continuing viability of price increases and liquidating all (or part of) their long positions that result in the asset price falling.

Structural Changes in Financial Markets

The mere possibility of the recent GameStop campaign has vividly illustrated some long-running structural changes in financial markets, beginning with the move toward passive, index-linked investment strategies that do not collect, process and incorporate information about individual issuers when deciding on their portfolio allocation. In this, they are joined by algorithmic trading strategies by momentum traders who follow short-term price trends.

This is accompanied by the large increase in leverage, enabled by both cheap and plentiful credit from trading accounts, low interest rates and the ‘wall of money’ after more than a decade of quantitative easing by central banks.

A third factor is the availability of virtually transaction cost-free trading apps, like Robinhood, that provide easy market access, including to options (leading to the possibility of gamma squeezes).

In addition, there has been a marked decline in investment bank research on individual stocks and an increasing reluctance to issue ‘sell’ recommendations (above all on struggling companies). The traditional function of investment bank equity research, involving reports on companies, securities and markets for clients, has been in decline for the last decade. The coup de grâce of the European Commission’s 2018 Markets in Financial Instruments Directive II (MiFID II), made this activity (almost) obsolete. MiFID II banned the ‘bundling’ of research with trade execution, compelling investment banks to price and sell their research as a separate product. This triggered a re-evaluation of the value of that research for clients, with many deciding that they could go without.

Finally, we have seen the increasing ‘democratisation’ of finance and ‘meme’ investing, best captured by Nobel Laureate Robert Shiller in his 2019 Narrative Economics book. The upshot is that markets nowadays rely less on notions of a fundamental value of an asset (and the associated research and analysis to uncover it) than the simple herd mentality generated by social media platforms and the powerful ‘fear of missing out’ of the social media age.

We should also not forget that these trends are occurring against the backdrop of the longest bull market in financial history. Overall, investors seem to be discarding the erstwhile long-term approach to financial investing guided by fundamental asset values, as well as the associated research and analysis. Capital markets are driven by flows and investor positioning, rather than by the underlying fundamentals of businesses.

Are the Days of Short Sellers Numbered?

Short sellers are best viewed as financial protestors rather than unethical investors, whose economic and financial impact is often either overestimated or deliberately exaggerated. While there may be some life left in the classical short selling strategy – the New York-based hedge fund Senvest Management LLC emerged as one of the biggest winners, making about US$700 million off GameStop’s volatility – short sellers are coming under attack from a series of structural changes in financial markets, which increasingly affect how investors behave and how funds can be deployed in future. This represents a two-pronged attack on short sellers. On the one hand, it has become easier to thwart their textbook strategy, while on the other, their contribution – of doing the research that other market participants should be doing – is losing importance.

It therefore remains to be seen how long the classical short sell business model can remain viable going forward. We may find ourselves in the paradoxical situation where the short-sellers’ role in keeping financial markets efficient in the face of these structural changes has become more salient than ever, but where these very same structural changes undermine the continued viability of short-selling strategies.

The after effects of the market gyrations involving short sellers, r/wallstreetbets and the shares of companies such as GameStop, AMC Entertainment and BlackBerry could result in the cost of borrowing stocks and the funding of short positions increasing in line with the emerging risks. In this regard, regulators may be tempted to re-examine both the proportion of companies’ free floats that can be shorted and additional capital requirements for brokers.

Finally, meme investors are not beyond betting against the market themselves. Despite their vehement ‘public’ aversion to short selling, ‘meme’ investors are very aware of their enemies’ favourite trading strategy: during the COVID-19 crisis in March of last year, r/wallstreetbets users eagerly advertised their purchases of put options on the S&P 500 index – in other words, bets on a large stock market downturn.