What do short-sellers really do?
They keep prices in line with fundamentals...but does that matter?
A lot of the populist anger related to the GameStop saga has focused on short-sellers. Why? Well first of all, normal people don’t do much short-selling, so it’s viewed as the purview of a wealthy elite. Second, short-sellers bet on companies’ stock prices to go down — not only does it seem sort of mean to bet on businesses to fail, but because most investors are long (i.e. make money when stocks go up), short-sellers profit when most people get hurt.
So why don’t we ban short-selling? Every so often, people start asking this, and economists and financial pundits march out to patiently explain why short-sellers are our friends, and we shouldn’t interfere with their good work.
But is that true? Let’s think about it carefully.
The theory: Short sellers correct overpricing
In financial economics, “market efficiency” means that the market price should reflect all available information. We can basically interpret that to mean that if the stock market is efficient, the price of a stock should equal the best possible guess of its fundamental value (i.e. the discounted future value of its free cash flows blah blah blah).
If you don’t allow short-selling, then it could be hard to correct overvaluation. Suppose Facebook stock is at $300 a share. And suppose half the people (let’s call them the “realists”) realize that Facebook is only worth $200 a share, and half are just crazy bullish and incorrectly think it’s worth $500 a share. Do their opinions just sort of cancel out? Well, no. Sure, the realists could push the price down by selling shares — if they had any. But remember, the realists think FB is overvalued at $300, so maybe they don’t actually own much of it, because why would you own an overvalued stock? Instead they already offloaded it to the optimists, who eagerly paid higher prices for it. Now the optimists own all the stock, and there’s no way to get the price back down to $200 by selling it.
Enter short-sellers. They borrow FB shares (from the optimists) and sell those shares, pushing the price down. Then in a little while when all the optimists wake up and realize that FB is really only worth $200 a share, and the price goes down, the shorts can buy the stock back for the cheaper price, return the shares to whoever they borrowed it from, and pocket the difference. That is how shorts make money.
Without short-sellers, it’s theoretically very hard to push stock prices down past a certain point. Many economic theorists have argued that this tends to lead to persistent overvaluation in the market. Without shorts, they predict, prices will be higher than fundamentals.
Some economists even think that short-sellers can pop stock bubbles, or prevent them from getting started. Maybe when prices rise because of a burst of optimism, it gets everyone’s attention and causes some people to think the rising prices are a new trend, so they all buy in and push the price to the moon🚀🚀🚀! Then the crash comes and regular folks lose their life’s savings to the savvy hedge funders who knew exactly when to time the top. But with short-sellers around, maybe that bubble would never get started, and normal people wouldn’t lose their life’s savings to savvy market-timing hedge funds, because they wouldn’t have seen that initial price rise to begin with.
It’s a theory, anyway.
OK, so that’s what short-sellers are supposed to do. They obviously can’t always do it, because in real life shorts don’t have infinite firepower (aka “liquidity”) to short stuff. If you get enough optimists together, you can overwhelm the hedge funds, and cause a short squeeze, which forces the prices even higher! 🚀🚀🚀
So whether short-sellers actually can stop bubbles in practice, we don’t know, since we don’t know entirely what causes bubbles to start forming, and at some point they get so big that shorts are powerless to stop them. (Though it’s worth noting that shorts do moderate bubbles in lab experiments.)
But anyway, theory says short sellers should at least be able to reduce overpricing on a day-to-day basis.
Are higher stock prices good or bad?
This is an important and subtle question. On one hand, regular people’s 401(k)s and IRAs and pension plans are invested in stocks, so when stock prices are higher, regular people feel wealthier. On the other hand, rich people have a much higher percent of their wealth in stocks compared to middle-class people, and poor people don’t own stock at all, so when stock prices go up, wealth inequality increases, at least on paper.
But does any of that matter? If stock prices are persistently above fundamental values, then the wealth isn’t real. The ability of companies to generate economic value remains the same. If people are willing to pay each other $1000 for a share of Facebook stock instead of $300, it just means they shuffle around more money each time the stock changes hands. So what?
Sure, the rich people are all richer on paper, but what are they going to do — sell all their stock to middle-class dopes, pocket the cash, and throw a party while the middle-class dopes are stuck with overvalued crap? Seems unlikely. Instead they’re going to just hang on to the overvalued stock, and go “Hrm hrm hrm, yay for me, I’m so rich!” Again, not a big deal, unless you’re one of the people who stays up late at night seething with rage at the thought of rich people feeling self-satisfied.
OK, one real thing it would mean is that Facebook, the actual company, would have an easier time raising money. Too easy! If Facebook’s shares sell for $1000 a pop, that means Zuck can just raise tons of cash by issuing some overvalued shares. Basically, Facebook’s cost of capital gets really low.
Economists generally think this is bad. If Zuck can raise money too easily, he’ll embark on inefficient projects and waste the money (and, more importantly, the time and effort of his employees). That will make the economy less efficient.
In reality, corporations rarely issue stock to fund their business activities. They almost always rely on debt instead. Maybe if stocks were really really overpriced, this would change — AMC, for example, is using a day-trading frenzy to issue stock to keep it afloat during the pandemic! But it seems highly unlikely that modest overpricings, of the type that short-sellers would be realistically able to correct, would move the needle at all on actual corporate finance.
In other words, it seems unlikely that a modest stock overpricing from a short-selling ban would have much of an effect on the real economy. If the S&P goes up by 10%, does the world really change at all?
But OK, on top of that, we have evidence that short-selling bans don’t even push prices up in the real world.
The evidence: Short-selling bans just gum up the works
Sometimes policymakers ignore the economists and ban or restrict short-selling anyway. And this allows economists to study what actually happens when you ban shorting. It turns out that short-selling bans are not quite as important as you might think.
For example, when Australia banned short-selling in the wake of the Global Financial Crisis, it made stock prices a bit more volatile, and made trading a bit more expensive, but it didn’t actually boost prices. Another study around the world from the same period found the same thing — bans on short-selling made stocks more volatile and more expensive to trade, but they didn’t actually make prices higher!
Remember that the theoretical reason shorts push prices down is that normal traders don’t actually have enough of the stock to sell when things go bad, because they’ve already unloaded it all to the most optimistic people in the market. That probably just isn’t that realistic. In the real world, people do usually have enough to sell when they get more pessimistic. So we probably don’t actually need shorts to keep prices from getting inflated, at least most of the time.
Now, that said, there are a whole lot of papers that find that when short selling is banned, stock prices respond more sluggishly to news and other shocks. This is pretty close to being an established scientific fact. In other words, short-sellers might not affect the overall level of prices much, but they help prices change faster when fundamentals change. That makes markets more “efficient”.
But again: Do we really care that much? Precisely zero companies are making business decisions or financing decisions based on whether their stock price takes 3 hours or 3 weeks to respond to a change in corporate value. Economists may feel a shiver of delight at the idea of prices making a swift, unerring beeline for their efficient value, but the actual economy is likely to be less affected.
There’s one more thing shorts might possibly be able to do that bears mentioning. If short-sellers short a stock enough, they can maybe possibly potentially drive down the price so much that the company gets delisted. At that point they make maximum profit, whether or not the company was perfectly healthy. Of course, it’s illegal to do that intentionally, but some people try to do it anyway — Jim Cramer once admitted to doing this on live TV. But this is really hard and risky to do.
Maybe short-selling just doesn’t matter that much
So what effect do short-sellers really have overall? They make markets work a little bit faster, and they damp out market swings a little bit. They might be able to stop some bubbles from forming, but we don’t really know. A few of them hunt down frauds. They might in rare cases murder companies for profit, but probably not.
As for whether or not short-sellers are The Man and long traders are The Little Guy, I highly doubt this proposition. Yes, shorts tend to be well-heeled hedge fund types. But really so do longs. In fact, so does pretty much everyone in the stock market — it’s a rich person’s game. The number of actual Little Guys who stand to gain from bans on short-selling is going to be miniscule.
Thus, it seems to make sense to have some modest, reasonable restrictions on short-selling (like bans on the dubious practice of naked shorting). But overall, short-selling bans don’t seem very likely to make a difference one way or another. That’s an answer that’s not going to please either side of the debate, of course.
Short sellers are crucial to the functioning of transatlantic finance. The reason is that we have a system where the marginal investor is a market-based intermediary — broker-dealers above all, but also hedge funds, large portfolio managers, and other risk arbitrageurs, along with real money investors like pension funds and endowments. The problem is that almost all of these marginal investors have a long bias. Broker-dealer banking firms are not only involved in market-neutral market-making, but also intermediate between money markets and capital markets by borrowing short and lending long. Their balance sheet positions are thus, under normal conditions, leveraged bets on the market going up. Most institutional investors, both large-scale portfolio managers like Blackrock and real money investors like CalPERS have largely long-only portfolios. Even most hedge funds make their money from at most market-neutral risk arbitrage strategies. Meanwhile, retail investors are almost always long. The short-sellers are the only ones in the business of keeping everyone honest through fundamental research. One can endogenize the capital allocated to short selling strategies in the manner that Shin et al. endogenize arbitrage capital (ie the folks holding dry power to buy up distressed illiquid assets like private equity and vulture funds). If you think along those lines, you can see how useful short-selling is to price discovery in a financial system dominated by long-biased financial intermediaries.
You left out one item that I often hear short sellers themselves claim as a benefit: it provides an incentive for investors to find fraud. Enron is a poster child of this.