There is still some confusion over short selling. This confusion leads people to support bans and restrictions on short selling which make very little sense. I think some of the concerns stem from simple misunderstandings and so I’m starting a public education campaign.
The simplest type of short sale is a forward sale agreement. If I enter a contract to sell a bicycle one week in the future I have made a short sale. If I own a bicycle at the time I enter the contract it is a ‘covered’ short sale. If I don’t own a bicycle at the time I enter the contract it is a ‘naked’ short sale.
Almost all commercial contracts involve a short sale because the delivery of goods comes after the contract is entered. Many are naked short sales, usually because the seller needs the cash to pay suppliers before they can provide a product.
From this perspective short sales are not very strange or scary. On the other hand if short sales are ‘selling securities you do not own with the intention to benefit from a fall in the price’ they sound quite strange and dodgy, possibly dangerous.
The confusion comes from convoluted explanations of repurchase agreements. A short seller will borrow a security for an agreed rental rate and immediately sell it for cash. When the time comes to give the security back to the lender he will purchase it at the market price. The lower the price when he repurchases the more money he makes.
Many people feel uncomfortable with this. Part of the discomfort probably stems from the process, which seems a little complicated. Part stems from the fact that it seems a bit dodgy to sell something that someone just lent you. Another part stems from the fact that the short seller wants the price to go down: he desires the misery of others. He might even attempt to manipulate the price downwards to further his evil agenda.
All this silliness can be dissolved by looking at another example of a short sale: a cash loan. If I borrow $10 for a week and use it to buy lunch I am short $10. I have borrowed the cash at a set rental rate, sold it immediately at the market price, and need to repurchase it before the loan is due. It is exactly the same process as short selling a stock, except now it is much less strange and scary.
The effect of short sales is unambiguously positive in terms of market efficiency. Markets work by agglomerating information from many buyers and sellers. Some people think a security is underpriced: they buy it and push the price up. Some people think it is overpriced: they sell (if they own it) or short sell (if they don’t). If short selling is banned a part of the market is not permitted to express their views on the price. The result is biased prices, at least temporarily.
The net effect of bans and restrictions on short sales is not necessarily higher prices. Prices eventually reflect value, even if they are initially imperfect. Market participants might rationally respond to a short selling restriction by selling any stock they own, anticipating the upward bias. The net effect on prices might be up or down, but volatility will certainly increase.
There are also broader issues of property rights and freedom of contract at play. Bans on short sales are enacted by preventing current holders of stock from lending it. The ban lowers the value of their property by denying them a rental income. This is simply an appropriation of property rights without just compensation.
Short sale bans have been popular government reaction to financial crises. Hoover condemned short sellers for their role in the 1929 crash and investigated their role in prolonging the depression. Various restrictions were introduced. In 2007-8 governments around the world responded to a market downturn by banning or heavily regulating short selling.
Short sellers are a convenient scapegoat for a crisis. Restrictions create the appearance of government action during a public panic. A witch is burnt; the villagers are appeased. Nothing changes. When the harvest fails again there will always be someone else to blame.