The Role Of Short Selling In A Healthy Financial Market

On the surface, it may appear that short sellers only profit off the failures of others, or specifically, the failure of a company. Although one can interpret it this way, the idea that short selling is unethical is rejected by almost all academics, practitioners and policy makers alike.

The ability to short sell serves a vital role in the financial markets, both contributing to market efficiency and plays an important role in detecting fraud. However, just as anything else in the finance world, it is a double edge sword with the potential to spiral markets out of control or facilitate market manipulation.

If you would like to first understand what short selling is, please read this article on the basics of short selling.

How Does Short Selling Combat Fraud?

Imagine you go to the casino and there is a simple game. Place a wager on a coin flip, if you call it right you double your money, and if you call it wrong, you lose your bet. Seems like a fair game.

Now let's assume you are only allowed to place a bet on "heads", which leaves you with two choices: play or not play. On the surface, this appears to be a fair game because you have a 50% chance of doubling your money. The issue comes when you look at the incentives for the house. 

Let's assume the house uses a rigged coin which has a 51% chance of landing on heads and 49% chance of landing on tails. You and a few others are aware of this while most people are not:

• If the ONLY option was to bet on heads (long), the rational choice would be to not play the game. But inevitably there will be people who will still play, including those who are unaware of the fraud. This means the house will earn a net profit. The optimal decision for the house in this scenario will be to continue to use the rigged coin.
• Alternatively, if you had the option to bet on either heads (long) or tails (short), the rational choice would now be to keep betting on tails and win money over the long run. If more people all bet in this manner, the house will start losing money. The optimal decision for the house in this scenario would then be to use a fair coin where everyone nets even over the long run.

Based on this simple example, it shows us that allowing bets on both sides helps naturally combat fraud by utilizing the incentive structures of the game.

We can extrapolate this to the stock markets.Investors can take either a long position or a short position on a particular stock. People who believe that a particular company is engaging in fraudulent activities are essentially casting their vote and having it reflected in the stock price of the company. 

But why does this matter? Why would a fraudulent company care about their stock price? And how is this beneficial to investors?

Other than the issue of CEO's getting inflated bonuses as a result of soaring stock prices, the main concern is where the source of the funds.

When a company wants to raise money through a new equity issue, they will issue shares to the market. If enough investors were to believe the company is engaging in fraud, the downward pressure put on by short sellers prohibits the issuing company from raising the desired amount of capital. This "invisible hand" type mechanism adds a layer of protection that prevents investors from overpaying for shares of a fraudulent company.

Real life high profile events that display of how short sellers helped combat companies that engaged in fraud

Wall Street Journal article on how short sellers James Canos detected red flags with the infamous Enron scandal

Wall Street Journal on how short sellers helped take down Luckin Coffee just a few years ago

The 2018 documentary file "The China Hustle" highlights the importance of how short sellers help keep the markets honest

You may ask, outside of incidences of fraud, what other purpose does short selling serve? I would argue that market efficiency is even more important than just the purpose of helping combat fraud.

How Short Selling Contributes To Efficient Markets?

What is an efficient market?

You may have heard about the efficient market hypothesis. There are a few different forms of beliefs, but the main idea is that for a market to be efficient, asset prices reflect all available information and opinions of the constituents of the market.

Why is this important?

Efficient markets fosters confidence in the system. This encourages market participation and allows businesses to raise capital to fund new projects.

The more efficient a market, the harder it will be to beat the market as more of the information is reflected in the asset prices. This is beneficial to the passive investor, which just happens to be the retail investor.

Now that we understand what market efficiency is, let's look at an example

Imagine there are two traders in who represent two different views of the market for Tesla ($TSLA). Neither of them currently own any shares. The current price of $TSLA is $850, and after careful analysis on the company:

• Investor A believes the $TSLA stock is worth $800; and
• Investor B believes the $TSLA stock is worth $900

We might conclude the price that most accurately represents both these views would be $850. At this current price, Investor A will short the $TSLA and Investor B will buy $TSLA. Assuming they have the same amount of funds to invest, this will mean the price of $TSLA remains at $850.

Now assume that short selling is prohibited. Investor A can no longer short sell $TSLA, while Investor B can still buy, increasing $TSLA's price to somewhere above $850. This is not what we determined as the price that most accurately represents the valuation of $TSLA.

Short selling allows investors who do not currently own the stock to have their views and analysis represented in the valuation of the stock.

Of course most markets do not actually function like this, but this is what makes investing in the stock market so unique, that even non-owners are able to effectively cast in their vote.

Summary

In summary, short selling is very important to financial markets. Although there is potential for big investors to engage in predatory activity, the benefits far outweigh the risks and this is also true on the long side.

Read my take on the whole GameStop, Reddit and Robinhood fiasco.