It is understandable that some people are on the lookout for villains to blame in this time of national crisis – and who better than City ‘fat cats’ who are ‘profiting from the misery of others’? But it usually only takes a moment of serious thought to realise that these attacks are well wide of the mark.
As Tom Bailey explains here, and I discussed here, it is plain daft to criticise investment managers for taking advantage of lower prices to buy shares. When funds are engaged in ‘short selling’, though, it may take a little more effort to see the bigger picture.
To explain, short selling is essentially a bet that the price of a financial asset will fall. It traditionally involves the short seller borrowing a parcel of shares or bonds from another investor and then selling them on. The original holder will charge a fee for this, which can be substantial.
At a later date the short seller will then repurchase an equivalent number of shares or bonds and return them to the original holder. If their price has fallen in the meantime, the short seller will make a profit (less the fees and other transaction costs incurred). But if the price has risen, the short seller will make a loss.
What’s to like about this? Despite its bad rap, short selling actually has three wider benefits.
First, it helps to keep the markets liquid. The presence of willing (short) sellers makes purchasing shares or bonds easier for those investors who do want to buy. The original holders (often insurance or pension funds) can also make a handy income from lending out the assets that they own.
Second, the activities of short sellers can provide useful information, for example in identifying companies whose shares or bonds are over-priced (or currencies that are fundamentally over-valued, such as sterling in 1992). (Credit rating agencies perform a similar role, and in my view they have recently been unfairly criticised for this too.)
Admittedly, short selling can itself depress prices. If it didn’t, it wouldn’t be sending much of a signal. But short selling is a potentially expensive and risky activity. In general, short sellers can only make any money if they turn out to be right about the valuation of the asset they are betting against (again, as when sterling was forced out of the ERM).
Third, the ability to hold short positions allows all sorts of financial institutions, as well as other businesses and individuals, to reduce risk. Indeed, one of many reasons why media headlines about the size of short positions run by particular funds are often misleading is because these shorts are being used to hedge much larger long positions. (Some short positions have to be reported, but long positions do not.)
Of course, some observers still regard short selling as potentially damaging, especially during a crisis. And some policymakers like to be seen to be responding to these concerns.
A handful of countries and regulators, including a few in the EU, have therefore increased reporting requirement or introduced bans on short selling in the last few weeks. But there is no evidence that this has helped to check the large falls in share prices: the stock market indices of countries that have imposed bans, notably France, Italy and Spain, have performed as badly, or worse, than those that have not, including Germany and the UK.
Where markets have recovered, it has been because of better news on coronavirus itself, or strong economic policy responses, not clumsy interventions in the setting of asset prices.
In the UK, the new Governor of the Bank of England, Andrew Bailey, has limited himself to an appeal to anyone engaged in short selling which might damage the economy (in some unspecified way) to ‘just stop‘. This appeal doesn’t seem to have much effect either, as the number of short positions in the shares of UK companies actually rose after his comments. But once again, these data alone are not evidence of harmful activity.
Indeed, as the Financial Conduct Authority (FCA) itself has spelt out, aggregate net short selling is still low as a percentage of total market activity, and there is no evidence that it has played a significant role in recent market falls. The FCA also flagged up the benefits of being able to hedge positions and the provision of liquidity.
Even if you still believe that short selling is immoral or unethical (and I do see why some might think that), almost all the academic evidence suggests that bans on short selling either have no significant impact, or that they actually make things worse (by reducing liquidity and distorting price signals).
Consistent with this, one frequently cited study (by Beber, Fabbri, Pagano and Simonelli) of the US sub-prime mortgage crisis and the subsequent crisis in the euro area found that those financial institutions whose shares were ‘protected’ by short-selling bans experienced greater volatility and were more likely to default than their peers. Even the head of the US Securities and Exchange Commission (SEC) was quick to admit that the 2008 ban on the short selling of bank shares was a mistake.
It wouldn’t make much sense either to impose an additional windfall tax on any profits from short selling (on top of the taxes that would already be due). For a start, it would be very hard to distinguish between ‘speculative’ trades and more ‘socially acceptable’ activities, such as hedging risks in larger portfolios.
There are also many ways of benefiting from falling prices (via options or derivative markets) without engaging in traditional short selling. Would these be taxed too (and how)? And if retrospective taxation did make short selling prohibitively expensive, this would have the same disadvantages as an outright ban.
In summary, the onus is on those wanting to ban short selling to make a much stronger case. It would be much better for policymakers to continue to focus on ensuring that anyone speculating against the UK no longer has a good reason to do so.