The Problem With Short Selling

Richard Murphy speaks:

And yet it’s attempt to raise cash in the market has been severely impeded by the wholly irresponsible action of short sellers in the market – mainly hedge funds. They have ‘borrowed’ shares from people like pension funds, then sold it, seen the price fall under pressure of a net selling market and then bought it back before returning it with a fee to those from whom they borrowed it. In so doing they seek to undermine the main function the stock market has, namely the creation of liquidity by the raising of cash for businesses that need it.

He entirely misses the point that short selling increases liquidity in the stock market.

Sigh.

14 thoughts on “The Problem With Short Selling”

  1. Tim

    Prove it

    Prove the benefit

    Suggest why there is a shortage of liquidity

    Explain why additional liquidity is, per se, of benefit

    Richard

    Tim adds: Erm, Richard, you are the person suggesting that the function of the stock market is to provide liquidity, aren’t you?

  2. There’s a certain irony here that the oil market, or at least observers of the oil market, are crying out for more short-selling.

  3. “the main function the stock market has, namely the creation of liquidity by the raising of cash for businesses that need it”

    He’s conflating ideas.

    One of the main functions of the stock market is to provide a liquid market for securities. This liquidity affords investors the ability to quickly and easily sell securities which, in turn, makes it easier for issuers to persuade investors to buy those securities . Short selling does not reduce the liquidity of securities – it increases it.

    What it can do is distort pricing which may in turn reduce the price at which securities can be issued. This could in some general sense of the word be said to reduce an issuer’s “liquidity” (e.g. the ability to convert its unissued capital into cash) but this is not the result of any reduction in the liquidity that the stock market is there to create. It’s the result of a pricing distortion.

  4. The problem is in the oil market is that there aren’t enough short sellers.

    If Richard Murphy was actually railing against an invidious practice called “naked short selling” then he might have a point. But in a properly functioning market there must be short selling when stocks become radically overvalued. Also, and this bit was missed, short sellers must BUY the stock in order to complete the trade.

    So Tim is correct – short selling is not a problem. In a stockmarket crash, it is the short sellers who return liquidity to the market when everyone else has run for the hills.

  5. The stock market is of far more value (and importance) to the whole of society than merely as the original source of investment capital for enrepreneurs or even for innovative ideas. In the first place, it is seldom (or never) the original source (which is usually entrepreneurs themselves, their friends, relatives, small “venture capitalists,” and various sorts of moneylenders). As an aside, it would be well to bear in mind that moneylenders, including banks, are also in the “at risk” position along with share-holding types of investors, subject to loss (though toward the front of the line in collecting); even collateral put up may become worth less (or, sometimes, worthless)

    What the securities market does for capitalist societies is to keep virtually everyone educated as to the values of everything: what’s traded in the market has been “commodified,” tending to press the subjective valuations of individuals to a specific “market price.” If not for the existence of such institution, the prices of various items individuals desired to acquire (whether for consumption or investment) would be more (not less) volatile, whether from place to place or from day to day. But that’s still not
    the entirety of the benefit. The other part is in the market’s function as an advisor to the entrepreneur, he who seeks profit–and all that goes with it–by correctly outguessing almost everyone else about the changes in value they themselves– the consumers–are liable to undergo tomorrow or the day after. And only when armed with this type of knowledge is the entrepreneur in position to judge the specific profitability–the “return on investment” of an anticipated action. Revenues, even when showing an excess of receipts over expenses, still cannot furnish such information without an up-to-date “handle” on the “I” portion of “ROI”–and that’s something that bookkeeping and accountancy cannot provide but which “the market” can and does.

    Those opposed to capitalism (and some not so opposed) very frequently distinguish between “investment” and “speculation” (the latter being regarded dimly, as a variant of casino or back-alley gambling). But all investment is gambling. (As Mises pointed out, every man gambles, each day, that he shall not be bitten by a viper.) The futures market is not different than other investment markets except in one major respect: it permits the maximum of refinement of the entrepreneurial “hunch” in the matter of the prices of such things as may be “commodified.” In at least this sense, the risk can be said to be “contained.” Those who believe the price of oil will rise significantly in the future have options on how to profit from their perspicacity. Some might actually buy oil itself and store it against the morrow–for their own use or to sell to neighbors. Some might go into the business, for themselves or with others, to drill holes in the ground. Others might buy stock in one or more of the major oil companies. But each of these is beset by risks almost completely unrelated to the market price of oil–I need not elaborate. Only the futures market provides a “pure play” on the price of oil, the aspect to which the original “hunch” pertained.

    Many see in “short selling” something ignoble–or even worthy of criminalization–akin to spreading false rumors–somehow “injuring” those with interests in the underlying business activity or who are “long” the particular market.
    We don’t know the motives–or, at least, all the motives–for futures-market activity. The one thing we do know is that the participants have “put their money where their mouth is” in some distinction to pundits, politicians, etc. It would be equally true to find the same fault with the “longs”–mightn’t we call them “pump and dumpers?” In the U.S., popular opinion sees something distinctly unpatriotic in someone (like Soros) making large profits by short-selling the U.S. dollar. Those buying pounds, yen, francs, Euros–escape criticism, though their increasing needs for these currencies are merely the mirror-image of the dollar decline.

  6. BlacquesJacquesShellacques

    But, but, short sellers are speculators, eeevil speculators.

    They don’t build things with their own honorably horny handed… hands. They don’t buy stocks for their own personal use which is the only proper thing. They don’t sell their own personally used and soiled stocks, no, they befoul and despoil stocks they have ‘borrowed’ from other and more honourable owners, those who kept their stocks clean.

    They are middlemen, running dogs…

    Ah, I quit, I was trying to write a completely loony comment, but Murph has me beat.

  7. Does the fact that shorting adds to liquidity really mean anything significant? Was the market short of liquidity before shorting became popular?

    Some people make the argument that shorting contributes to efficient prices but that seems to rest on the assumptions that investors are behave irrationally when they go long, and that markets tend towards equilibrium, both of which seem a little shaky to me.

  8. Tom P – “Some people make the argument that shorting contributes to efficient prices but that seems to rest on the assumptions that investors are behave irrationally when they go long, and that markets tend towards equilibrium”

    No, the argument is that if it is impossible (or even merely difficult) to go short then the only people in the market are those who think the stock will rise in price. The price of the stock will therefore only reflect the information contained in the most optimistic assessments of its value, and will therefore be overvalued. We need not assume anything about the rationality of the individual investors or any tendancy towards “equilibrium” of the market. We do however have to assume that there are no systematic biases in investors assessments of stock values.

  9. Hi Robert

    I might be being thick here but I don’t quite follow that. Surely investors still sell even if they can’t short, and shorting itself is just selling, but with borrowed stock. So even the price of a stock that has been shorted will reflect, at a given point, the most optimistic views on its values.

    “We do however have to assume that there are no systematic biases in investors assessments of stock values.”

    That’s what I was getting at when I mentioned rationality. Shorters are subject to biases too, whereas the implication in a lot of discussions around this issue seems to be that shorting is somehow more rational. Maybe I am reading to much into it.

    To be honest I’m still a bit undecided whether shorting is a problem. The stock-lending that facilitates it might be the bigger issue.

  10. There’s another, more technical point: under the CAPM, without the ability to hold short positions in a portfolio, not all of the points on the minimum variance set are accessible to you. You therefore potentially forgo a certain amount of return for a given risk.

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