Who Gets Harmed When You Ban Short Selling?  January 29, 2021

Neil Ramsey 

Published Jan 29 2021

If your real problem with short selling is that you think it's an evil way for fat cats on Wall Street to get even richer by betting against the little guy, think again. In the seven months following the fateful brick through the cybertruck window, Tesla sold 650,000 cybertrucks¹ that hadn’t even been made, so this particular argument against short selling is dead on arrival.

I can only assume Elon Musk is being sarcastic or possibly self-serving. At this instant, short sellers might be the only thing distancing him from being worth more than Jeff Bezos (well, that and real economic value). At least a few of the 635 thousand people who liked the tweet, though, are probably thrilled that Citron discontinued short selling research this morning because to them: short selling is evil and ought to be banned.

Short selling is not evil, and it needs to stay in place if we want to have free markets. Short selling is a wonderful gift to liquidity and efficient price discovery. Markets thrive the more diverse the holders and traders of securities are. It’s what provides efficient pricing and liquidity for all investors.

Without this type of broad price discovery, the less efficient capital formation will be for the entire economy. The value of short selling is going to be straightforwardly displayed in the next couple of weeks. GME, who as of the posting of this article has just surpassed United Airlines and 106 other companies on the S&P500 in market cap, is going to attract retail investors who do not know what they are doing and want to get in on the fun. At some point, GME is going to crash. With all the short sellers squeezed out of their positions, the stock price has become almost completely meaningless.

Many retail investors will not understand this fact and will buy GME at 336.19 (TIMESTAMP 11:03 AM). When you bar short sellers (or discriminate against any class of participant), entrant retail investors are the real victim, subject to a form of phony price inflation.

One could draw a parallel to silencing voices of political dissidence. If you ban the people who think your “price” is errant (too high), it looks like you (or your ideas) are worth more than they actually are. Get 1000 people to go online and scream that the truth is a lie. It may work for a short time but ultimately the victim is the same, the innocent participants that don’t have the time or the expertise to adjudicate the truth on their own. That’s who making markets free is meant to help. Allow all ideas and opinions to have their say, and the truest ones will rise to the top. Price discovery and public debate have similar dynamics. Both serve to discern the collective truth.

If your real problem with short selling is that you think it's an evil way for fat cats on Wall Street to get even richer by betting against the little guy, think again.

First of all, short selling does bear (lol) one major similarity to evil; it rarely pays off in the long-term. “The stock market always goes up” is a commonly repeated and dangerous phrase, but it's actually kind of accurate. Since 1980, the S&P500 has been up in 76% of 6 month windows². So by definition, most short trades are losers. The truest depiction of short selling is not Ryan Gosling getting a 47 million dollar check for his risky bet against the American housing market in The Big Short. It’s a long-short equity manager who is exposed to more retail risk than he’d like and short sells Cheesecake Factory for 3 months. At which time, CAKE rallies 14% for no discernable reason, and he’s forced out of the trade.

Second of all, this is a funhouse image of the landscape of market participants, which, like most things in our society, is very complex. Before you go celebrating Melvin’s big loss on GME, here’s an interesting fact: US Pension funds, who manage the retirement funds of our nation’s teachers, firefighters, etc., allocate over $900 billion to more than 2,500 long-short equity investment managers³, like Melvin, as of March 2019. The hundreds of millions of dollars Melvin lost this week did not come out of Steve Cohen’s bank account. Well, maybe some of it did. The point is: the big scary institutional investor is often an amalgamation of little guys, not so different than the Reddit GME mob.

Retired hobbyist investing, momentum investing, value investing, short-term mean reversion like statistical arbitrage, growth investors, day traders, short sellers, even Reddit mob investors; they’re all part of a market mechanism that ultimately leads to better long-term price discovery mechanisms and add depth and liquidity to the market place. Whether Tesla is worth 1500, 800 or 50 a share, it’s this mechanism that flushes out the true long-term economic value of a security.

Ban short sellers or any other market participants at your peril.

References

1. Wedbush Securities.
2. Bloomberg.
3. Hedge Fund Research, Inc (HFRI).