Short-sellers Face Hardship - Not Good for Markets
Challenges faced by short-sellers and their potential impact on market dynamics
If you hope to be well-liked, it is best not to be a short-seller. Some investors may theoretically defend you as an integral part of the financial market, but to the majority of people, you are a ghoul who takes advantage of the misfortunes of others. You could even be seen as a corporate raider, wagering that reliable companies will fall and then spouting false information about them until they do. Even those who are sympathetic to your cause will abandon you if you choose the wrong firm to target (ones they own) or the wrong time (a market crash where many are suffering losses while you are making a profit).
Regulators have often been among the fair-weather friends that have added to a list of short-selling bans that dates back to the 17th century in the Netherlands, to 18th century Great Britain, and to Napoleon Bonaparte. The most recent one was declared on November 6th by South Korea's Financial Services Commission. It is widely discussed, not just by local retail investors who blame shorts for a weak stock market, but also by Wall Street's meme stock traders who view themselves as heroic amateurs challenging the villainous short-sellers.
On November 17th, renowned American short seller Jim Chanos sent an update to his investors, announcing the closure of his primary hedge funds. Chanos noted that the funds had reached a point where it was no longer economically feasible to run them, which he defined as "a few hundred million". At its peak in 2008, his company managed between $6bn and $7bn, after predicting the downfall of energy company Enron. The firm's short bets have yielded its investors close to $5bn since it was established in 1985.
The traders who continue to practice short-selling are facing two potential risks. The first is the traditional one of regulators, spurred on by those who look upon this type of investing as immoral, taking restrictive measures. The second, more dangerous, possibility is that investors are losing interest in this form of investing and no longer wish to fund it. If these short-sellers succumb to either of these dangers, the allocation of capital in the financial markets will be less efficient and investors will suffer.
It is often argued that betting on asset prices declining is immoral, suggesting that short-sellers drive down prices, causing losses for other investors and hindering companies or governments from raising capital. This disregards the fact that those targeted by shorts are typically those who have misled investors, such as Enron. In this case, short-sellers are the only people with a substantial financial motivation to uncover the fraud and prevent even greater losses. The same is true of firms that are overvalued. Had short-sellers been able to puncture the dotcom bubble or the recent ones in SPACs and meme stocks earlier, it would have saved investors from buying in too high and losing their money.
In contrast, there is a lack of proof that short-selling depresses values. Wolfgang Bessler and Marco Vendrasco of the University of Hamburg conducted a study of six European countries who banned short-selling during the 2020 crash and discovered that such bans did not help to stabilise stocks. Rather, they reduced liquidity, resulting in a greater discrepancy between "buy" and "sell" prices, making transactions more expensive. Additionally, the stocks of smaller companies, often seen as victims of major short sellers, were more negatively impacted due to a decline in market quality.
If short-sellers are able to prevent the second risk and encourage their financiers to stay with them, they can inform the rest of the market of assets they think are overpriced. They have been successful in this regard: Adani Enterprises, a massive Indian business that was publicly shorted by Hindenburg Research in January, has seen its share price drop 39% since the beginning of the year. These assertions may be driven by self-interest, but this is no different than any other asset manager hyping up their portfolio.
Investment banks, PR consultants, and the companies themselves are all proponents of optimism and hype, as opposed to the killjoys who take the opposing side. Markets function better and capital is more effectively allocated when there are individuals who take a more cautious approach. Since stock markets, particularly in the US, are nearing their all-time highs, funds that are dedicated to short-selling may be particularly beneficial to investors. According to Mr Chanos, since it is so unpopular, it is more affordable than ever.
