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.
Even if most companies raise financing via debt, don't forget that companies often secure lower interest rates by issuing convertible debt. The funds that buy convertible debt rely crucially on short-selling the underlying stock to hedge their risk: https://en.wikipedia.org/wiki/Convertible_arbitrage. If short selling was not possible, this would limit the amount of convertibles that these funds could buy, which would directly translate into higher interest costs on corporate debt for companies.
I think you're underweighing the discipline that equity prices instill on management.
While you're correct that equity prices generally don't impact companies by allowing them to raise more capital, they do impact the choices that management makes — replacing a CEO, or acquiring other companies, or using cash for buybacks, or selling themselves to a better-managed acquirer.
A more efficient stock market — with short sellers — will mean these choices are made faster and more accurately.
It's not even very apparent that a more efficient valuation function (3 hours vs 3 weeks) is really all that useful. Fundamentals rarely change all that swiftly; what *does* change swiftly are the broader fundamentals of the finance system. Individual company fundamentals ought to be insulated from finance's, since finance's impact on the broader economy is already priced in to individual fundamentals.
I'd focus regulatory efforts on capping (hard or soft) minimum short-borrowing periods, and incentivizing longer short-borrowing periods. Since it's clear that short selling isn't really doing its theoretical functions - disciplining prices/bubbles - those functions need to be reinforced, and the best way to do it is to expand their time horizon.
So, Noah, do you believe _The Big Short_ really was the pin that pricked the mortgage-backed securities bubble back in '07 or so?
I've seen it persuasively written up that way (sorry, haven't read the book itself): everyone, even the banks, knew these CDOs were crap, but their prices went on climbing because there was no way to short them. Until there was.
Perhaps this is incidental but to the extent we want to have functioning option markets - both to improve market transparency and liquidity - shorting is also a necessary element of the “replicating portfolio” that underlies pricing. Whether or not options are necessary or good is I suppose open to some debate. But the simple act of buying puts to protect a long portfolio ultimately requires a short to be executed.
Another method of predatory shorting that's not discussed is Short and Distort schemes, where short sellers take short positions and then release false information about the company they're shorting. This can be hard for smaller companies to correct — as the saying goes, a lie can travel halfway around the world while the truth is still putting on its shoes.
the utopian dream is rather than a chaotic stock exchange with HFT firms optimizing down to the nanosecond, just have a nice, orderly auction. maybe a few times a second if you don't want to shake things up, maybe a few times a day if you're a real radical.
Eleventy-seven years ago I went through a similar argument with myself about shorting, but with a lot smaller number of specific "if this then that" 's than NS. Same conclusion. :-)
On the predatory front there are companies where the only real funding option is via raising money via stock sales. Biotech is a prime example where they raise initial money in an IPO for a phase one exploratory clinical trial then use the stock as currency for later stage trials. You can argue this is a bad business model but that is the way it is done, and in this instance short sellers, by depressing the stock price, can make it all but impossible to raise new (or enough) money to move to later stage trials and the firm goes bankrupt.
at incentive level is also broken since you create an incentive to make a business fundamentals deteriorate, and is incredibly more easy to destroy something than building it, so ceteris paribus rationally you should short something and then pay a % of that to disrupt their business (if you think this is difficult you live in a fantasy, you should understand there is difference between books and real life)
also you fail to notice that if buy side can be wrong equally can sell side, and if this happens then there is a distortion upward that surely bring the price even more distant from this bs idea of "true" price
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.
Even if most companies raise financing via debt, don't forget that companies often secure lower interest rates by issuing convertible debt. The funds that buy convertible debt rely crucially on short-selling the underlying stock to hedge their risk: https://en.wikipedia.org/wiki/Convertible_arbitrage. If short selling was not possible, this would limit the amount of convertibles that these funds could buy, which would directly translate into higher interest costs on corporate debt for companies.
It's really great! I like this resource, but sometimes I also use http://essaypapers.reviews/ to get some educational help.
I'm confused by the seemingly contradictory statements that on the one hand
> short-sellers ... help prices change faster when fundamentals change
and on the other hand
> bans on short-selling made stocks more volatile
what is the definition of "volatility" that would make these statements non-contradictory?
Similarly, what's the mechanism by which banning shorts would make trading more expensive?
I think you're underweighing the discipline that equity prices instill on management.
While you're correct that equity prices generally don't impact companies by allowing them to raise more capital, they do impact the choices that management makes — replacing a CEO, or acquiring other companies, or using cash for buybacks, or selling themselves to a better-managed acquirer.
A more efficient stock market — with short sellers — will mean these choices are made faster and more accurately.
"There’s one more thing shorts might possibly be able to do that bears mentioning." I see what you did there. Bears. Cool.
It's not even very apparent that a more efficient valuation function (3 hours vs 3 weeks) is really all that useful. Fundamentals rarely change all that swiftly; what *does* change swiftly are the broader fundamentals of the finance system. Individual company fundamentals ought to be insulated from finance's, since finance's impact on the broader economy is already priced in to individual fundamentals.
I'd focus regulatory efforts on capping (hard or soft) minimum short-borrowing periods, and incentivizing longer short-borrowing periods. Since it's clear that short selling isn't really doing its theoretical functions - disciplining prices/bubbles - those functions need to be reinforced, and the best way to do it is to expand their time horizon.
So, Noah, do you believe _The Big Short_ really was the pin that pricked the mortgage-backed securities bubble back in '07 or so?
I've seen it persuasively written up that way (sorry, haven't read the book itself): everyone, even the banks, knew these CDOs were crap, but their prices went on climbing because there was no way to short them. Until there was.
Perhaps this is incidental but to the extent we want to have functioning option markets - both to improve market transparency and liquidity - shorting is also a necessary element of the “replicating portfolio” that underlies pricing. Whether or not options are necessary or good is I suppose open to some debate. But the simple act of buying puts to protect a long portfolio ultimately requires a short to be executed.
Another method of predatory shorting that's not discussed is Short and Distort schemes, where short sellers take short positions and then release false information about the company they're shorting. This can be hard for smaller companies to correct — as the saying goes, a lie can travel halfway around the world while the truth is still putting on its shoes.
https://www.investopedia.com/terms/s/shortanddistort.asp
the utopian dream is rather than a chaotic stock exchange with HFT firms optimizing down to the nanosecond, just have a nice, orderly auction. maybe a few times a second if you don't want to shake things up, maybe a few times a day if you're a real radical.
Eleventy-seven years ago I went through a similar argument with myself about shorting, but with a lot smaller number of specific "if this then that" 's than NS. Same conclusion. :-)
On the predatory front there are companies where the only real funding option is via raising money via stock sales. Biotech is a prime example where they raise initial money in an IPO for a phase one exploratory clinical trial then use the stock as currency for later stage trials. You can argue this is a bad business model but that is the way it is done, and in this instance short sellers, by depressing the stock price, can make it all but impossible to raise new (or enough) money to move to later stage trials and the firm goes bankrupt.
https://youtu.be/qtkaMx12otQ http://counterfeitingstock.com leaving that apart
at incentive level is also broken since you create an incentive to make a business fundamentals deteriorate, and is incredibly more easy to destroy something than building it, so ceteris paribus rationally you should short something and then pay a % of that to disrupt their business (if you think this is difficult you live in a fantasy, you should understand there is difference between books and real life)
also you fail to notice that if buy side can be wrong equally can sell side, and if this happens then there is a distortion upward that surely bring the price even more distant from this bs idea of "true" price