If I wanted to, could I legally sell the Brooklyn Bridge to you? Of course not! Why? Because I don’t own it!
If the law won’t allow me to sell the Brooklyn Bridge, how can I sell you shares in a company that I don’t own? Well, surprisingly, I can, as long as I can “cover” my position at some time in the future.
The legal right to short stocks and even whole markets to create investor panic gives wealthy people a very unfair advantage over everyone else. If I believe that a particular company’s stock will fall within a short time, nothing stops me from shorting the stock and selling a couple of hundred shares, in the hope that I could buy them back at a lower price later on. I would simply have to sit and wait for events to unfold.
On the other side of the coin, if several fund managers and/or investment houses got together and shorted a few million shares, flooding the market would automatically cause the price to drop. Small investors would quickly panic thereby precipitating an even larger decline. At the right time, the “big boys” would cover their positions while the “little guys” would be wiped out.
When I did some research on the origin of short selling, I came across a fascinating article on Wikipedia. I think it makes for worthwhile reading.
“Some hold that the practice was invented in 1609 by Dutch merchant Isaac Le Maire, a sizeable shareholder of the Vereenigde Oostindische Compagnie (VOC). Short selling can exert downward pressure on the underlying stock, driving down the price of shares of that security. This, combined with the seemingly complex and hard to follow tactics of the practice, have made short selling a historical target for criticism. At various times in history, governments have restricted or banned short selling.
The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, precipitating a major crisis which included the collapse of almost every private bank in Scotland, and a liquidity crisis in the two major banking centers of the world, London and Amsterdam. The bank had been speculating by shorting East India Company stock on a massive scale, and apparently using customer deposits to cover losses. It was perceived as having a magnifying effect in the violent downturn in the Dutch tulip market in the eighteenth century. In another well-referenced example, George Soros became notorious for “breaking the Bank of England” on Black Wednesday of 1992, when he sold short more than $10 billion worth of pounds sterling.
The term “short” was in use from at least the mid-nineteenth century. It is commonly understood that “short” is used because the short seller is in a deficit position with his brokerage house. Jacob Little was known as The Great Bear of Wall Street who began shorting stocks in the United States in 1822.
Short sellers were blamed for the Wall Street Crash of
- 1929.Regulationsgoverning short selling were implemented in the United States in 1929 and in 1940. Political fallout from the 1929 crash led Congress to enact a law banning short sellers from selling shares during a downtick; this was known as the uptick rule, and this was in effect until July 3, 2007 when the Securities and Exchange Commission removed it. President Herbert Hoover condemned short sellers and even Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression. A few years later, in 1949, Alfred Winslow Jones founded a fund (that was unregulated) that bought stocks while selling other stocks short, hence hedging some of the market risk, and the hedge fund was born.”
(My Note: a hedge fund is simply an investment pool that can either go long or short based on the decisions of its management.)
“Negative news, such as litigation against a company, may also entice professional traders to sell a stock short in hope of the stock price going down.
During the Dot-com bubble, shorting a start-up company could backfire since it could be taken over at a price higher than the price at which speculators shorted. Short sellers were forced to cover their positions at acquisition prices, while in many cases the firm often overpaid for the start-up.”
Naked short selling restrictions
During the 2008 financial crisis, critics argued that investors taking large short positions in struggling financial firms like Lehman Brothers and Morgan Stanley created instability in the stock market and placed additional downward pressure on prices. In response, a number of countries introduced restrictive regulations on short selling in 2008 and 2009. Investors argued that it was in the weakness of financial institutions, not short selling, that drove stocks to fall. In September 2008, the Securities Exchange Commission in the United States abruptly banned short sales, primarily in financial stocks, to protect companies under siege in the stock market. That ban expired several weeks later as regulators determined the ban was not stabilizing the price of stocks.
Temporary short-selling bans were also introduced in the United Kingdom, Germany, France, Italy and other European countries in 2008 to minimal effect. Australia moved to ban naked short selling entirely in September 2008. Germany placed a temporary ban on naked short selling of certain euro zone securities in 2010. Spain and Italy introduced short selling bans in 2011 and again in 2012. Worldwide, economic regulators seem inclined to restrict short selling to decrease potential downward price cascades. Savvy investors continue to argue this only contributes to market inefficiency.
Short selling stock consists of the following:
- The speculator instructs the broker to sell the shares and the proceeds are credited to his broker’s account at the firm upon which the firm can earn interest. Generally, the short seller does not earn interest on the short proceeds and cannot use or encumber the proceeds for another transaction.
- Upon completion of the sale, the speculator has 3 days (in the US) to borrow the shares. If required by law, the speculator first ensures that cash or equity is on deposit with his brokerage firm as collateral for the initial short margin requirement. Some short sellers, mainly firms and hedge funds, participate in the practice of naked short selling, where the shorted shares are not borrowed or delivered.
- The speculator may close the position by buying back the shares (called covering). If the price has dropped, he makes a profit. If the stock advanced, he takes a loss.
- Finally, the speculator may return the shares to the lender or stay short indefinitely.
- At any time, the lender may call for the return of his shares e.g. because he wants to sell them. The borrower must buy shares on the market and return them to the lender (or he must borrow the shares from elsewhere). When the broker completes this transaction automatically, it is called a ‘buy-in’.
Shorting stock in the U.S.
In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a “locate.” Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security.
The vast majority of stocks borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies. Institutions often lend out their shares in order to earn a little extra money on their investments. The custodian who holds the securities for the institution usually arranges these institutional loans. In an institutional stock loan, the borrower puts up cash collateral, typically 102% of the value of the stock. The lender, who often rebates part of the interest to the borrower, then invests the cash collateral. The interest that is kept by the lender is the compensation to the lender for the stock loan.
Brokerage firms can also borrow stocks from the accounts of their own customers. Typical margin account agreements give brokerage firms the right to borrow customer shares without notifying the customer.
Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the “locate” process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.
Stock exchanges such as the NYSE or the NASDAQ typically report the “short interest” of a stock, which gives the number of shares that have been legally sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares legally sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements but in order to be reliable, investors must also ascertain the number of shares brought into existence by naked shorters. Speculators are cautioned to remember that for every share that has been shorted (owned by a new owner), a ‘shadow owner’ exists (i.e. the original owner) who also is part of the universe of owners of that stock, i.e. Despite not having any voting rights, he has not relinquished his interest and some rights in that stock.”
My strong recommendation is that shorting of shares on any U.S. stock exchange should be completely outlawed. Taking this step would go a long way towards leveling the playing field for all Americans.
In recent years, new investment vehicles have emerged called Exchange-Traded Funds (ETFS). An ETF holds assets such as stocks, bonds, commodities and currencies and trades close to its net asset value during the trading day. There are also ETFs that track an index, such as the Standard & Poor 500 and the Dow Jones Industrial Average. An ETF is an example of a “derivative.” A derivative is simply an investment vehicle that is derived from something else, called the “underlying”. For example, the value of a Dow Jones Industrial Average Fund at any moment in time is derived from the underlying values of the stocks of thirty large U.S. corporations. No magic! Really!
Conceptually, an ETF is an interesting concept since one can, for example, buy into an index fund, like a Dow Jones Industrial Average fund, instead of trying to buy into thirty different stocks. An ETF shares many characteristics of a mutual fund. However, the downside is that they can also be used by the very wealthy to manipulate markets, since there are also ETFs that are set up to short specific classes of investments.
I therefore recommend that a prohibition on shorting be extended to U.S. ETFs as well.
Obviously, the current crisis is mainly due to the potential of a Global Coronavirus pandemic coupled with downward pressures that are destabilizing the price of oil internationally. Even professional investors are powerless to deal with these issues, but I believe it would be unreasonable to have them take advantage of a bad situation and make it worse.