Opinion
Short selling is often seen as a predatory practice engaged in by “vulture” traders. But outlawing it may adversely affect the market.
The experience of a nasty sharemarket sell-off can be made even more stressful for an investor who learns their beloved shares are being “short sold” by rapacious hedge funds and gunslinger traders.
Not surprisingly, with many markets around the world enduring their worst start to a calendar year for decades, suggestions of a ban on short selling have resurfaced again, including in the Australian sharemarket.
Critics have likened short-sellers to vultures. AP
But research shows such bans are not only ineffective at stopping share price declines, they can be counterproductive.
Short selling is where an investor sells shares that they don’t yet own, so it’s essentially the reverse of normal share trading.
They do it because they think the share price is going to fall, and the profit they stand to make is the difference between the selling price and the price the shares are bought back for. So, if a share is sold at $15 and bought back at $10, the profit is $5, or 33 per cent.
The practice of short selling is often seen as predatory, and the traders who do it as no better than vultures. At the height of the global financial crisis in 2008, short selling was banned on various international stock exchanges, including the US, Britain and Australia, in an effort to improve market confidence and reduce volatility. ASIC eventually limited the ban to short selling financial stocks.
Then in response to the sharp stock market falls in March 2020, at least seven countries banned short selling again.
However, a number of studies after the 2008 financial crisis to analyse the effectiveness of banning short selling concluded it had little effect on prices but did reduce market efficiency. For example, in 2011, the Federal Reserve Bank of New York concluded that “banning short selling does not appear to prevent stock prices from falling”, but instead “lowered market liquidity and increased trading costs”. The European Systematic Risk Board reached similar conclusions.
The increased trading costs were attributed to the buy-sell spreads on shares widening. In other words, investors paid higher prices to buy or received lower prices when selling. Other studies have found that being able to readily short sell is associated with markets that are more technically capable and boast higher turnover, which is generally viewed as a proxy for better “liquidity”; that is, the ease with which investors can trade.
Indeed, in an interview at the end of 2008, when the then-chairman of the US Securities Exchange Commission was asked about the success of its short selling ban, he said: “Knowing what we know now, I believe on balance the commission would not do it again.”
In a sophisticated stock market like Australia’s, short selling plays a critical role for many funds that hedge their risk. For example, a “market neutral” fund aims to drastically reduce the volatility of its returns by pairing long positions against short positions; and “long-short” funds will use short selling to either protect investors’ capital and/or increase returns.
Funds such as these can produce terrific results for their investors, which include mums and dads and SMSFs. For example, one of Australia’s leading long-short funds has a record, over the long-term, of not participating in market falls but capturing all the market rises.
Because the ASX reports short selling on a stock-by-stock basis, it doesn’t reflect that most short selling has a corresponding long position paired with it. For example, a fund might buy BHP and hedge the position by selling Rio – not because they think Rio will necessarily go down, but simply that it will underperform BHP.
As for predatory short selling, that is very difficult in Australia because all short positions have to be “covered”, meaning the seller has to borrow shares from an existing holder, which incurs costs. So, the risk of a hedge fund attacking a small-cap company is greatly reduced because borrowing shares in small companies is much harder and more expensive.
Share prices eventually always reflect fundamentals. Successful short selling requires skill, in the same way successful long investing does. If an investor has the skill to identify that a company’s share price doesn’t match its fundamentals, then it makes sense they should be able to profit from that knowledge. And modern share markets do smart investors a disservice if they ban it.
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