By Tim Fox, Head of Demand Generation

Why short-selling is a misunderstood scapegoat

Whether you’re a pension fund manager, day-trader or a crypto evangelist, you would have felt the heat these past few months – and not just because parts of Europe and the United States have been baking in record temperatures.

The first half of 2022 has been the worst in 50 years for financial markets – the S&P 500 alone shed some $8.5 trillion in value. Sensible market watchers know what to blame: inflation, rising interest rates and stretched valuations – caused by record low rates and eye-watering amounts of stimulus cash washing through the markets – which we’d come to see as normal. But there are some out there who see darker forces at work. They point the finger at an altogether more nefarious culprit: short-sellers.

Convenient scapegoat

For some commentators, short-sellers make for a convenient scapegoat. By borrowing a stock now, selling it, and then buying it back later at a hoped-for lower price – so their argument goes – they have a vested interest in market declines. Ergo, if markets fall, it must be their fault. These leaps of logic are often backed by cherry-picked evidence such as how authorities banned short-selling during the Global Financial Crisis (GFC). If they took this action, it must be bad.

This is not accurate. Short-selling has been around for decades. Aside from the short-lived ban during the GFC, it provides a legal, regulated activity that helps the market in many ways including sometimes helping uncover fraud. If regulators in Germany had paid more attention to why investors were shorting Wirecard, they may have noticed the shenanigans that caused the payments processor to implode.

Why does short-selling get such a bad rap?

Perhaps modern retail investors just love meme stocks, like Gamestop or AMC, and don’t like the thought of those big, mean hedge funds shorting the little guy?

For those of a particular vintage, their perception of short-selling may be tainted by the classic book Reminiscences of a Stock Operator. In it, the day-trading anti-hero, Jesse Livermore, speculates his way to a fortune, partly on the back of aggressive “naked” short-selling, i.e. he sold vast volumes of shares – often way in excess of the available stock – without borrowing them in the first place. The book was fiction. Naked short-selling is illegal. Although it does still happen, doing so on the industrialised scale of Reminiscences is tricky and can land the perpetrator in serious regulatory trouble.

Shorting for good

If shorting isn’t a bad thing, is it a force for good? That depends on your view of financial markets. If you believe in investing and efficient capital markets, then the answer is yes. Take this example: you want to sell 1,000 Tesla shares. Someone buys them. Trades are meant to settle after two days (T+2). In practice, the buyer will probably receive the shares instantaneously, courtesy of stock that was borrowed by her broker.

Short-selling also enables options trading – something popularised by meme stock day-traders, but used by everyone from banks and brokers to airlines trying to ensure they don’t have to pay full whack for jet fuel. Short-selling can help hedge risk. For other investors, it’s another market signal.

Then there’s the securities lenders who facilitate the short-selling process. Generally, they will be long on an asset, hoping it will go up in price. By lending it out – especially when dividends are coming under pressure and valuations are volatile – they can generate an additional revenue stream that can partly offset any loss in yield, while maintaining all the benefits of ownership.

Then there’s the regulators themselves. SEC Chairman Gary Gensler – not known for his fondness for speculation – said in November: “Securities lending and borrowing is an important part of our market structure. In today’s fast-moving financial markets, it’s important that market participants have access to fair, accurate and timely information.”

All the more reason to enable all investors – big and small – to have access to securities lending, while increasing transparency in every corner of the market.

While the heat may not be to everyone’s taste, sunlight, as they say, is the best disinfectant. The more the industry digitizes and democratises, the clearer it will become that short-selling was always just a misunderstood scapegoat – instead of being recognised for being the force for efficient, liquid and open capital market that it is.