Short sellers and investor protection

Author Name: 
Josh Galper
Josh Galper's photo.jpg

The recent financial crisis has shown that clear lines must be drawn between protecting investors and allowing market participants to freely express their opinions of securities prices. Short sales directly benefit stock markets by supporting price discovery and enhancing liquidity, and indirectly by facilitating operations for the alternative funds industry. At the same time, outsized short selling during volatile times can unfairly damage stock prices and create systemic economic risks. This note aims to help define the line between investor protection and unfettered short selling, which to date has proven to be a substantial challenge for regulators and markets alike. 

It is much easier to focus on the dangers of short selling than to understand the benefits. In 2008 the media and general public seized on the downside of short selling, with front page articles in major newspapers discussing its ill effects. This is not the first time short selling has been in the limelight: on October 18th, 1930 the New York Times ran a front page editorial noting “the demand from irritated watchers of the situation that the evil influence of such stock market operations be ended by suspension or outright prohibition of ‘short sales.’”  

A consensus has emerged that naked short selling represents the worst of market excesses. Naked short selling, when a stock is sold short without having borrowed the security for delivery, creates significant distortions in stock prices by artificially creating more shares for sale than legally exist. With no equivalent demand a stock’s price will fall, damaging market integrity for issues and investors. While it is unfortunate that naked short selling was allowed to persist for so long, the decisive action by a majority of exchange regulators around the world means that naked short selling is mostly gone, although room for short-term naked shorting still exists in some markets.

Ordinary short selling can also create trouble for the markets. Like excessive optimism, when stock prices can jump in a bubble due to public excitement about market performance, excessive pessimism can cause stock prices to fall beyond any recognition of fair value. This pessimism can be fueled by short selling, and healthy stocks can be trampled along with weak ones. Left unchecked, a short selling bubble could inadvertently become the tool for damaging an entire economy. 

The last eighteen months may have proven the reality of this bubble pessimism. As stock prices decline, creditors fear the viability of their counterparties leading to a classic run on the market, or in some literal cases a run on the bank. The interdependence of major corporations in a modern economy means that one large failure can easily compound into another, leading to major economic disaster.

Click here for full article

About Joshua Galper

Josh Galper is the lead for Finadium’s research and consulting practice. His expertise focuses on trading, clearing, settlement and custody. Josh has conducted numerous consulting assignments on prime brokerage, securities lending, algorithmic trading, market data and transaction cost analysis. His prior roles include corporate development at Merrill Lynch, running Electronic Trading at Sanford Bernstein & Co., LLC, and consulting to the World Federation of Exchanges. 

Josh has been quoted in major international newspapers and magazines and in most industry publications covering hedge funds, securities lending and the markets. He holds an MBA in Financial Engineering from the MIT Sloan School of Management, an MS from Cornell University and a BA from Connecticut College.

Finadium is a research and consulting firm focused on financial services and financial technology. The firm conducts assignments on alternative asset services including securities lending, margin, prime brokerage, fund administration and custody. Finadium produces eight independent research reports annually and hosts an annual conference. Clients include hedge funds, asset managers, broker-dealers, custodians, exchanges, technology companies and private equity firms. 

For more information on Finadium, please visit us at www.finadium.com.