Short Selling is Bad for the Market
April 9, 2009
Theft is theft, no matter what you call it…
So… the SEC is fielding commentary on what to do about short selling abuses in the market. There’s a lot of hoo-hah about the so-called ‘uptick’ rule, but from where I sit, this is a mere red herring, distracting people from the basic structural weakness of the entire system of short selling.
A friend shared one piece of such commentary today, attributed to famed short seller Jim Chanos.
"Rebuilding investor confidence should be the primary objective of any new regulatory effort and it is not clear that today's proposals will meet that simple goal. Skeptics, independent research and critical analysis must continue to play a vibrant role for our markets to grow sustainably and with integrity. Short selling is integral to improving the efficiency of markets and enhancing market quality through narrower spreads, deeper liquidity, less volatility, and greater price discovery. In recent years, short-sellers have publicly warned the marketplace about the dangers at AIG, Lehman Brothers, and Enron, as well as sounding the alarm over the credit ratings agencies, non-bank subprime lenders, and credit insurers. Proposals to inhibit short-selling have the effect of limiting this vital market-based antidote to corporate fraud and speculative bubbles, and must be carefully weighed against the clear harm that comes from ill-conceived government intervention in basic market functions."
Again, I find myself not sure whether to laugh or cry, as I shake my head reading such piffle. To me, it’s like saying that serial bank robbers have done a service to improving security at banks. The suggestion that short selling has served to reduce volatility in the markets is more unwashed balderdash.
I cannot, for the life of me, understand why this conversation even needs to take place. The concepts are simple. The inherent flaws are plainly there to see for anyone possessing two neurons to rub together.
Proponents of short selling would have us believe that their activities are a healthy process, serving to ‘cull the herd’ of weak players. In a market full of companies representing little more than a name and a piece of paper, such culling activity per se has merit. It has always been my understanding, though, that this is a process well served by the ‘free market’. Money flows to good companies. Money runs from bad companies.
But wait! The free market is what these folk would have you believe supports the concept of short selling. After all, Wikipedia says, “A free market is a market that is free of government intervention and regulation…” So, let the market find its own path and level, they say. What they neglect to include (also from Wikipedia) is the idea that a free market, “… is also free of private force and fraud.” We are now seeing in the light of day what lack of regulation has done for the free market.
Supporters of short selling will have you believe that naked short selling is a nominal activity… it’s a minor by-product, a mere annoyance in the shadow of overwhelming benefits.
For those not comfortable in their understanding of short selling and naked short selling, here they are in a nutshell. A short seller borrows existing stock, sells it at what s/he believes is an inflated price, waits for the market to work its magic, and then buys it back at the lower price, returning the borrowed shares, and pocketing the difference. Naked short selling is the sale of stock that doesn’t exist, with the same end profit in mind. Broker complicity is necessary for this to happen. To the extent that the broker business is largely self-regulated… also known as unregulated, the temptation is substantial for many to reach out and steal from the poor, the weak, and the disenfranchised… also known as the lay investor.
I’m not going to get into the structural weakness that allows such abuses. This should be self-evident, and others have presented the case more than adequately. A very few can always ruin a picnic for the very many. ‘Caveat Emptor’ doesn’t fly with me on this. Never did. Because you can’t catch me stealing from you doesn’t make it any more acceptable. Short selling is not, as claimed in the cited passage, a ‘basic market function’. It is a constructed instrument, created to side-step the basic market function. The net result is a stick thrown in the spokes of what would otherwise be a much more transparent and free-flowing market.
I will borrow my late father’s line (again) and say, “let’s take a few steps back for a wider angle on this.”
Here’s the thing. You figure that a company in which I own shares is overvalued by the market, and that share price is likely to fall. Accordingly, you decide to borrow shares to sell them short. Now, hold on a darn tootin’ minute there, pardner. Where are you going to borrow those shares? Somebody owns them… maybe they’re my shares. Why in the name of all that is good would I lend shares of a company to somebody whose only purpose is to see their value go down? I would not. It would never happen. Never!
So, how do you get your mitts on my shares? You go to my broker and make some arrangement to borrow my shares for this purpose. What I want to know is: How is my broker acting as my broker when s/he lends my shares, without my knowledge, to someone bent on creating a disservice to my interest. This is a structural flaw that seems to have been missed by so many, while too focused on how to dress up short selling for the ‘protection of the market’. You can put a fancy dress on a greasy hog, and paint its face with lipstick and rouge… but no matter… it’s still a pig.
All of the discussion about share price manipulation, driving prices down, naked shorts, painting the tape, etcetera, is moot. What must be addressed is at the very root of the issue. How is my interest served when someone with an opposing interest is able to use my own assets as the instrument of my demise.
Let’s go back to the herd culling metaphor for a moment. You’ve got a herd of reindeer, neighbouring my own. My herd is doing just fine, and has promise for some serious gains in value for me when I eventually take it to the market. You covet the value embedded in my herd, and see it (in relative terms) as a threat to your own wealth. In a zero-sum game, the more I have, the less you have. So you pay my herder a finders fee, and sneak into my herd at night, slitting the throats of my prized possessions. Selling off the meat which you do not own, your interest alone is served… along with that of my corrupted herder. You have used my own assets to destroy my wealth, and in so doing, advance your own.
Yet, you declare this to be the essence of a free market. It just isn’t so. Volatility in the market is created, promoted, and fed by short selling, and all the backroom antics that accompany it. Let the free market be a real free market. If you think a share price is going to go down, sell it… or don’t buy it. This is the essence of a free market. Tools created to benefit the few who have access are not servants of a free market. They represent only a concentration of undue influence… and as we all know, when undue influence gathers in select quarters, those quarters become dollars very quickly, at the expense of all other players in the game. As they say, when you look around the room and can’t find the mark, chances are you’re it.
Stop short selling altogether, I say. The greater good will most certainly be served. Who will lose? Only those who now benefit from the losses of others. I can live with that. In short (pun intended) I say…
Kevin Graham