Short sellers are misunderstood

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Short selling has always had an image problem. The investment strategy — which involves selling a borrowed asset expecting its price to fall, then buying and returning it — is often associated with callous bankers gaining from others’ misfortune. The 2015 Hollywood film, The Big Short, which documents the billions some traders amassed by betting against the US housing market in the run-up to the global financial crisis, brought the practice to wider consciousness. Alongside the moral qualms, critics claim “shorting” stokes panic, crashes stock prices and punishes the public. The authorities have frequently responded by clamping down on the practice — the latest attempt comes from South Korea.

This month, the Financial Services Commission in Seoul placed a ban on short selling listed stocks until June 2024. Sceptics suggest it is a political effort to appease local retail investors — who have become a dominant force in the stock market — and to cast traders as the “bogeyman” for low prices ahead of elections in April. The FSC says it is actually trying to root out more egregious forms of short selling. Whatever their reasons, the arguments put forward by detractors of short selling rarely hold up. The share trading strategy is a core part of a healthy and transparent free market. Banning it is not only harmful, it is also ineffective.

First, short selling facilitates price discovery. As short sellers are exposed to potentially heavy losses if prices do not fall, their trades are often underpinned by intensive research. And, by putting downward pressure on prices, the practice helps return over-performing stocks to a fairer valuation. The arbitrage opportunity also provides a financial motive to dig deep into companies’ finances. Jim Chanos — who recently decided to close his hedge fund, citing pressures on the short equity business model due to bullish markets — pocketed millions after detecting financial inconsistencies at both Enron and Wirecard prior to their bankruptcies.

Second, it supports liquidity and risk management. During the financial crisis, several countries including the US enacted bans on short selling over concerns that it would exacerbate bear markets. Research by the New York Fed found that the ban did not prevent stock prices from falling. It also led to lower liquidity and higher trading costs. A study of bans in six European countries in March 2020 had similar findings, noting that smaller stock markets and firms suffered most.

Third, regular investors are likely to be worse off without short sellers. Lifting constraints on “shorting” has been shown to reduce the risk of a market crash, by improving business investment efficiency and providing valuable information. Indeed, the trade acts as an important check on market optimism, which has a tendency to turn into a bubble. Research by the UK’s Financial Conduct Authority also suggests that the marketwide benefits of active trading could be diluted if the less costly passive fund management industry grows disproportionately large.

There are, however, malicious forms of the trade. “Short-and-distort” strategies involve “shorting” a stock and then spreading false information. This is already illegal, but the authorities need to ensure they can identify and respond to cases even faster, particularly as social media platforms help amplify their attacks. “Naked shorting” — or selling stocks without borrowing, or arranging to borrow, them — is also rightly banned in many jurisdictions, as it raises the risk of unsettled trades.

Korea’s FSC claims its ban is to tackle naked short selling. But market participants dispute that the practice is prevalent or even profitable. Either way, given the integral role of short selling for financial market quality and efficiency, South Korea’s ban only undermines its longstanding ambition to be upgraded to developed market status by leading index providers. In subdued or falling markets, short sellers are routinely scapegoated. But the authorities and the public need to remember that looks can be deceiving.