Friday, September 19, 2008

Selling Short: The debate

One of the big news items competing for attention today was the SEC's decision to bar short selling temporarily on more than 700 financial service companies. While the SEC statement paid the usual lip service to the importance of allowing short selling in orderly markets, it also concluded that short selling was contributing to market instability and should not be allowed for the moment.
Implicit in the ban, and in the support that it is getting from many investors and portfolio managers, is the assumption that short sellers are bad people - speculators, naysayers and vultures who make money off long term investors. I think that short sellers, like long buyers (why not?), cannot be easily categorized. Some are motivated by good information, some are trading on rumor and some can be unscrupulous (floating false news stories to bolster their positions). While the ban may have helped markets today, here is why I think it is counter productive:
1. If we want market prices to reflect all news, good as well as bad, we have to allow people to trade on both types of news.
2. Investors who believe that the prices of Citi, Chase or Goldman are going to drop in the next few weeks can evade the ban by using options or other alternatives. In effect, banning short selling is either going to push it deeper underground or make the carnage worse on the financial service companies where other alternatives exist.
I do believe that investors who take positions in stock - long or short - should be held accountable when they try to manipulate the price afterwards. That is an enforcement issue that the SEC should be thinking about rather than short circuiting the process.


Unknown said...

Is it possible for the sec to punish false information being purveyed to the marketplace? It's not illegal to be, well, dumb; so what's to keep a short seller from pleading ignorance?

mpc said...

We should all recognize that short selling benefits long buyers. In a parimutuel betting system like the equities market, the more bettors on one side of a particular bet, the worse the odds become for those bettors. By taking the opposite side, short sellers improve the odds for long buyers. Temporarily banning short selling, unfortunately, improves the odds for short sellers when the ban is lifted.
On the other hand, mark-to-market accounting bolsters the phenomenon that George Soros calls Reflexivity. As Steve Schwarzman has stated, introducing mark-to-market accounting during the beginning of the downturn has exacerbated the problem.