Womenz Magazine

Should short selling be banned following GameStop’s surge

It is often claimed that short sales are manipulative and drive down prices.

Is this the case?

Or are short sales in fact a vital part of the market? Indeed, Elon Musk even entered the fray with a (self-serving) tweet against short sales.

Short selling is fundamental to ensuring correct market prices.

The overwhelming majority of academic papers in leading peer-reviewed journals shows that short sellers make market prices more efficient and incorporate more information more quickly into market prices so that prices reflect firms’ true values.

Short selling is not manipulative per se, because the costs involved in manipulating prices through shorts are often prohibitive, and regulatory scrutiny is ample enough to prevent it.

Short selling does, however, help to ensure stock prices represent firms’ true values, thereby ensuring what is called “market efficiency”, helping firms raise capital, and giving people confidence that when they buy stocks, they are less likely to be buying at a frothy price that reflects mispricing.

What is short selling, and how do profits and losses work?

Short selling involves borrowing a stock in order to sell it into the market. Usually, the seller borrows the stock from a pension fund or other passive index fund.

In return, the fund receives fees. This helps to slightly juice earnings for the fund, whose investment mandate would have stopped them from taking a short position themselves.

Short sellers must deposit money as security (called the margin account). The amount of security can depend on the broker and the trader.

For some volatile stocks, the margin amount can exceed the value of the shares. This imposes indirect limits on short sales.

The return to short selling is the difference between the current share price and the price when they sold the shares. Short sellers gain when prices fall and lose when they increase.

How does selling shorts impact prices?

Short sellers cause many direct and indirect benefits. We should start with the observation that markets function better when prices reflect firms’ true fundamental values.

The firm’s fundamental value is merely the present value of all expected earnings. Short sellers help to achieve this. This occurs because if the price is too high, short sellers will sell the stock. This can cause the price to lower back towards its true value.

The academic literature overwhelmingly shows that short selling is beneficial. As far back as 1987, it was clear that short selling was beneficial, helping to ensure prices adjust when new information is released.

Recent evidence highlights that shorts are beneficial. A 2011 study published in the top tier Review of Financial Studies analysed 12,600 stocks across 26 countries.

The study found: (1) better access to short selling is associated with greater market efficiency (which in turn, causes pricing accuracy), and (2) allowing short-selling does not increase price volatility or the risk of extreme returns. Such findings have been confirmed elsewhere.

A 2018 paper in the top tier Journal of Finance shows that stocks, where there are barriers to short selling, in fact, have lower returns and less pricing accuracy.

Another 2013 paper in the Review of Financial Studies uses intraday stock prices for stocks on the NYSE. It found that prices are more efficient, and information incorporates into prices more quickly when there are short-sellers.

Short sale benefits

Short sellers help to ensure the market is fair for investors. If prices systematically deviate from firms’ true value, retail investors especially risk paying too much for shares.

This would cause them to lose money when the firm’s poor earnings reach such a point that investors desert the company.

Short sellers help to prevent this from happening, thereby helping retail investors over the long term. This encourages market participation, which is good for everyone.

Short sellers help with efficient capital allocation and cause economic growth. If prices are systematically incorrect, some firms will be overpriced and some potentially underpriced.

In this case, the underpriced firm would never raise capital, because they would receive too little money for each share they issue.

The overpriced firm would issue significant capital, aware that it would then be able to exchange its overpriced equity for cash, which it could use to buy something less overpriced.

Thus, some firms will have too much money for their growth prospects and some firms will have too little. This ultimately would drive down economic growth. By preventing this scenario, short-sellers are good for the economy and provide a social service.

Short sellers help mitigate bubbles. By selling overpriced firms, short-sellers can help smooth out bubbles. They cannot eliminate bubbles. For example, if there is wide-spread ramping, whereby people buy to just force up share prices, the short sellers will naturally be unlikely to prevent that behaviour.

However, on average, short sellers will be able to help prevent prices reaching irrationally high levels. This is beneficial because bubbles ultimately hurt the people who buy at bubbly prices and these are often retail investors.

Short sellers have other indirect benefits. By helping prices move towards their true value, short-sellers help in other ways.

For example, having accurate prices is inherently beneficial in corporate bankruptcy prediction. This, in turn, is essential for accurate debt pricing and for prudential control, and, over the long term, reducing the amount of excessively risky loans.

Is short selling harmful?

The next issue is whether short selling can harm firms or individuals. We should note that short-sellers do not impact corporate fundamentals.

Short sellers do not cause company bankruptcies. Short sellers do not cause lower earnings. Short sellers do not cause unemployment. Indeed, it is not even clear that the presence of short-sellers is per se related to lower returns.

Rather, it is plausible that because short sellers can be active, people have more confidence in prices, causing more pricing accuracy and higher returns.

Short selling also does not generally place long term downward pressure on prices. This is because there are significant risks involved in doing this. First, it is costly. The short seller would have to borrow stock and pay associated fees. Second, it is risky.

If prices move opposite to how short sellers predict, they stand to lose significant wealth. This risk could arise due to random market movements, or due to the short seller incorrectly valuing the firm.

In either case, the risk is significant. Third, it is illegal and given the amount of shorts that would be required, the regulator could easily detect any trading designed to push down prices.

Where to from here then?

Politicians must do their homework before trying to restrict short selling. They should inform themselves about what short sales do, and do not do.

The academic literature shows that short selling improves the market by ensuring prices are more likely to cohere to firms’ true value and by quickly and efficiently incorporating information into prices.

There is little evidence that they are used manipulatively, at least not on a systematic basis.

Short selling should not be curtailed. People who do not acknowledge the scientific literature in this respect are akin to anti-vaxxers or climate deniers, deluding themselves as to what the academic literature actually says.

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