Regulators to the Rescue?

Market authorities across many European countries have announced plans to prohibit short-selling (to varying degrees) for the foreseeable future.

Short-selling bans, while perhaps politically appealing, are empirically unhelpful.  These bans make markets less efficient, not more; as they impact liquidity, destabilize flows, and widen bid-offer spreads.  Furthermore - and this is so counterintuitive it makes the politicians and bureaucrats’ heads spin – they actually eliminate potential buyers of shares down the road. 

There perhaps are some cases in individual sectors where such bans could be warranted (e.g. tail-wagging the dog sectors like banks dependent on metrics related to the market value of their equity)  but broadly they are an epic fail.  There is plenty of research out there showing this is the case.

Short-sellers aren’t the reason the stock market screamed lower this month.  The market moved lower because the corona virus and our reaction to it is impacting the global economy.  Individual equities would have plummeted with or without short-sellers.   Sure, they are an easy target, but the truth is that the shorts serve a function; they provide liquidity and flow, and – most importantly – ensure equilibrium. 

Finally, it is very easy to overlook that those managing long‐short equity products also happen to be trying to make money for their clients. The majority of these clients are pension funds, endowments, and charitable foundations; and these firms have entrusted hedge fund managers with their capital and are counting on them to generate positive – indeed uncorrelated – returns over the long term. If these managers can identify an opportunity where short‐term investors are over enthusiastic about a company’s prospects or that a management team is in fact misleading the investing public, then it is the job of the short seller to capture the profit from making that price efficient.  This has the added benefit of helping to prevent the retail investor overpaying for shares.

Whether we are buying or selling and in whichever order – that’s how price discovery happens.  And price discovery is a good thing.