Should Shorting Stocks Be Illegal?

The Plaintiffs' Case Usually, my headlines are, ahem, rigged. As did Socrates, I ask the questions knowing where the answers will lead. (The comparison between us ends there.) Today's column is different. In response to Friday's installment, many readers advocated banning the practice of shorting. This article addresses that suggestion, while containing no preconceived notions. I have no horse in this race.

We’ll start by defining the proposal’s scope. One can profit from investment losses by: 1) shorting directly, 2) selling call options, 3) buying put options, 4) selling futures contracts, or 5) entering swaps. This article addresses only the first tactic, that of shorting directly, and only for individual stocks. Such a rule would not prevent investors from trading options on S&P 500 futures, selling Thailand White Rice contracts, or engaging in credit default swaps.

I received four reasons for abolishing the practice of stock shorting:

1) Profiting from company failures is immoral.

2) The practice is damaging because it artificially lowers stock prices.

3) It’s a privileged investment tactic that is not available to everyday investors.

4) Short sellers manipulate the market, by conspiring.

It's Immoral Friday's column pointed out that short sellers are not the only investors to benefit from unhappiness. For example, the healthcare industry would not exist if people did not suffer. True, hospitals and drug companies profit from fixing problems, but the fact remains that were illness eliminated, those firms would go bankrupt.

In hindsight, that contention wasn’t very convincing. When unhappiness occurs, healthcare providers attempt to alleviate it, while short sellers do not. The difference between those two actions is meaningful. A stronger objection, I think, is that the immorality claim is situational, rather than principled. That is, those who decry profiting from corporate losses are happy to do so, if they believe the opposition deserves its fate.

For example, some of the short sellers that GameStop's GME buyers squeezed were employed by publicly traded firms. Few mourned the fate of those companies' shares. More broadly, many investors for political or religious reasons dislike certain industries, such as tobacco, guns, and liquor. They typically do not short those stocks, but neither do they shed tears over their stock market woes.

This is not to refute the argument. I appreciate its merits. I am, however, thinking about the matter, as Jack Benny would say. (Today is my 60th birthday; permit me a moment's nostalgia.)

It's Harmful Assume a stock costs $80 per share, and that an investor wishes to establish an $80 million short position. He will do so by borrowing 1 million shares, and then immediately selling those shares for cash. Later, the short seller will return those shares to the lender, after purchasing them on the open market. If the stock price has declined between the time of the borrowing and repayment, the short seller makes money. If on the other hand they have risen, the short records a loss.

Such are the mechanics of shorting. By selling shares that they do not possess, short investors temporarily reduce stock prices, because if those transactions had not occurred, fewer shares would be available for buyers to purchase. However, as amply illustrated by GameStop’s behavior, the reverse also holds. When short sellers cover their positions, they boost prices by increasing demand.

Thus, the claim that short-selling hurts companies by depressing stock quotes is incomplete. It describes the outgoing leg of the journey, but not the return. Nonetheless, the criticism might be valid. Although short sellers ultimately do not affect how firms are valued, they do disrupt the normal bid/ask process. Perhaps the benefit of permitting such trades is not worth the disruption.

It's Privileged Few retail investors short stocks, which is a credit to their intelligence, since most short trades flop. Over time, stocks tend to rise rather than fall; borrowing costs for short positions can be steep; and unlike with a long purchase, there is no theoretical limit to the potential loss of a short position. Shorting is a mug's game, which is why almost all shorts do so while hedging long positions, rather than as a solo endeavor.

That said, retail investors certainly may short if they wish, by using margin with their brokerage account. Thus, the argument that short-selling is purely a technique for the wealthy and/or institutions does not hold. It is true that retail investors who are not accredited cannot own hedge funds--but they may, if they wish, short stocks directly.

It's Conspiratorial The final charge against short sellers is that they collude to sully the reputations of the companies that they short, by spreading bad news. Such behavior does occur, and it is unsavory. On the other hand, abetted by those who own long positions in their shares, and who therefore will profit from price appreciation, CEOs routinely exaggerate their company's prospects. Is cheerleading by the bulls more attractive, or better for the economy, than brickbats from the bears?

That, I confess, was a rhetorical question: I think not. To be sure, if short sellers lie about a company, for personal benefit, they should be held liable for their words--just as company managements commit securities fraud for such behavior. Also, if short sellers conspire to reduce a stock’s price by making their trades in unison, they are guilty of market manipulation, and should be treated as such. But otherwise, I see no harm in investors voicing their opinion. It’s a free country.

Wrapping Up I don't find the argument against the short sales of stocks to be very powerful. From what I can see, the strongest reasons to prohibit short-selling are: 1) the general belief that desiring bad outcomes is immoral; and 2) the possibility that short sales contribute to market instability. The first concern rests upon a slippery slope, while the second allegation is unproven.

However, it must also be admitted that there aren’t substantial grounds for permitting the practice, either. The stock market doesn’t need short sellers to police the actions of long investors; what drives down stock prices is the absence of bids, not the presence of shorts. What’s more, those who feel that they need hedge against stock market declines can do so through either options or futures.

In summary… eh. My inclination is to accept the status quo, on the principle that, all things being equal, the fewer regulations the better. But I am happy to hear counterarguments. It might be that I am wrong.

Another Perspective When speaking about the financial writer Michael Lewis, a co-worker said, "He likes black hats and white hats, but not gray hats." Truer words were rarely spoken. Lewis's narratives are compelling because they have heroes and villains. In Moneyball, Billy Beane and his analytics teams are the heroes, and the old-school scouts wear the black hats. In The Big Short, short-selling hedge funds have the white hats (oh, the irony), and Wall Street investment banks are the villains.

In Flash Boys, of course, the miscreants are high-frequency traders, or HFTs, while the virtuous are those who oppose them. So far, so good. However, it should be remembered--but often is not--that Lewis's primary source when writing Flash Boys were a deeply interested party: the founders of a brokerage firm that sought to take business away from the HFTs.) If I were unkind, I might even say that Lewis's sources behaved as do short sellers, by talking down the competition.

For an alternate take on the services of HFTs, see last Friday's "People Are Worried About Payment for Order Flow," by Bloomberg's Matt Levine. Of different views markets are made.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.