Wednesday, November 26, 2008

Why Bans On Short-Selling Reduces Market Efficiency

Pehr has once again posted a question in my Q&A section of such great general interest that it deserves a separate post. His question was as follows:

"Today at our finance lecture one student asked the teacher the following question:

"Is there any negative effects for the economy by a banning short selling?"

And the teacher answered by saying that he didn't know or couldn't think of any negative effects by doing this.

My instinct though says that a banning of short-selling is NOT good for the economy but I cannot explain why. I don't have any arguments except that it interfers with the free market.

Do you have a better answer on this question?"


Yes, I do. Banning short-selling delays price adjustment to the correct value. The efficient market hypothesis is based on the assumption (as well as many other assumptions) that short-selling is possible. While I don't believe in the efficient market hypothesis for other reasons (that is, many of those other assumptions are wrong), it is correct in noting that the ability to sell short helps move markets closer to that ideal.

If a certain stock (or other asset) is overvalued, yet the people who realize this have already gotten out of the stock, then the way for them to correct this overvaluation is to sell the stock short. That way, these informed investors can bring the price closer to its fair value. But if short-selling is banned, this kind of adjustment can't take place.

Another aspect of this is that people who for some reason believe a certain stock is too cheap can use their money or even borrowed money to buy stocks they think are too cheap. Yet people who come to the conclusion that a certain stock is overvalued can't do anything about it unless they already owned the stock in the absence of short-selling. And even those that already owned the stock are limited to their stocks, while people bullish about the stock could possibly borrow to buy more of it. This creates an asymmetric situation where people bullish about a stock will have much greater influence than those that are bearish about it, which increases the risk that some stocks will be over-valued.

This would be similar to say an election where both Republicans and Democrats had the possibility of voting for the Republican candidate , but only those who had previously voted for the Republican candidate could vote for the Democrat, while previous Democratic voters who wanted to support the Democratic candidate could only have the option of abstaining from voting (abstaining from buying, so to speak) for the Republican. It should be obvious just how great bias for the Republican candidate this would create. Similarly, bans on short-selling creates a significant bias for bulls that distort stock prices and makes markets less efficient.

15 Comments:

Anonymous Anonymous said...

"And the teacher answered by saying that he didn't know or couldn't think of any negative effects by doing this."

That to me demonstrates serious lack of knowledge about the stock market and markets in general and their purpose. What was the title of this course?

11:35 PM  
Anonymous newson said...

stefan, you say "bans on short-selling creates a significant bias for bulls that distort stock prices".

but short-selling doesn't change the overall price direction, only reduces the volatility. banning it, doesn't change the trend either, just makes the highs higher and the lows lower. so i would question the use of "bias". see: us onion prices, with a futures contract vs without (pre- 1958 vs post).

more importantly, what's your take on naked short-selling (for me it's fraud and economically destructive, but i'm all ears).

4:21 AM  
Anonymous Pehr said...

Well, it's called "Finance" and is given by one of the largest technological universities in Sweden.

/Pehr

12:15 PM  
Blogger marc.van.den.bosch said...

I think there are more arguments for short selling. For one it increases market liquidity, thus lowering the bid/ask spreads which are a tax on the investor.

However (always playing the devil's advocate somehow) I think some thought should be given to some extreme consequences caused by shortselling. Especially in situations where the short bets are very high compared to the company's free float. You are familiar with the case of Volkswagen, where massive bets against its stock caused it to become (how ever briefly) to become the largest company by market cap in the world. Hardly supportive of the efficient markets argument.

Could you perhaps consider if certain limitations could do away with those side-effects?

5:34 PM  
Blogger stefankarlsson said...

Newson, short-selling does change the overall direction as it increases the number of sellers, which means that except during extreme cases of short-covering in illiquid markets (see Marks example of Volkswagen), prices will either be lower or as low as without short-selling (that effect is however mitigated to the extent that proceeds from the short-selling is re-invested in other stocks in the meantime).

As for volatility, short-selling could just as well increase it as decrease it. If during a bear market short-sellers increase bets, then stocks will fall more than otherwisem while the following rally will be even more dramatic as short-sellers unwind their posititions. But that increase in volatility is (or could be) a good thing as it means that prices adjust faster.

Mark, yes the Volkswagen was hardly a case of market efficiency . But these extreme movements were very short-lived and hardly did much damage except to the hedge fund managers who foolishly sold Volkswagen short. And these hedge fund managers have now suffered greatly for their mistake.

8:13 PM  
Anonymous newson said...

stefan: i know the arguments against empiricism, but the onion is a pretty good lab experiment http://blogs.ft.com/undercover/2008/07/the-onion-has-no-futures/

but even on a theoretical level, covered short-sales cannot affect medium-term trend. once the short-sale is made, that party is necessarily a future buyer. so the effect is negated over time. the only affect is to adjust the price more rapidly in line with the fundamentals.

a market without short-selling may well go higher without the corrective sales, and the fall will be more precipitous, as there is no profit-taking by the shorts along the way.

in your bear-market argument, if there were no shorts, the longs would dump stock and quite possibly not return. the shorts will cover at some point to realize profits.


only naked shorting can distort prices and raise volatility, by effectively counterfeiting securities. i'm not sure whether this is as rampant on the dax (in the volkswagen example) as it is in the us.

12:55 AM  
Blogger happyjuggler0 said...

Short selling also has other benefits than outlined above.

One thing that short selling does is that it gives investors who want to buy stocks a way to hedge their overall market exposure. If you ban short selling, then it is reasonable to expect a selloff of stocks that hedgers have long positions on. This will depress a lot of stocks that are underpriced, while obviously also raising the price of stocks that used to be shorted, which likely many of them are overpriced and will become even more overpriced.

It is important that stocks be priced as close to their "intrinsic" value as reasonably possible. If not, then you get bubbles, which in turn misdirect entrepreneurs into the bubble area. The dot com boom/bust is a great example of this, countless resources, both in terms of money and human capital were wasted on companies that never had any hope of making a profit, and hence they were destroying wealth.

Imagine instead of the wealth being destroyed in the dot com boom, there was no bubble and instead all that money invested in profitable companies. All those new alternative companies would be employing people, as contrasted with all the layoffs and related hardships that happened when the bubble popped.

Additionally, in the alternate universe where the money was invested profitably, these companies would have been making products and services that people actually valued (hence the profits).

With those profits earned from actually profitably creating something real, these companies would typically reinvest most of that money, and based on past perforance that would likely have been profitable too, thus making even more jobs, and the new jobs would be sustainable.

To make a long story "short", shortsellers, if they are profitable then they helped bring the stock price down to a level that more correctly reflects the company's fundamentals. In so doing, these short sellers on a stock by stock basis help prevent entrepreneurs from starting companies in fields where new supply isn't needed. Instead entrepreneurs start up somewhere else that looks more profitable, thus benefitting society by creating sustainable (i.e. profitable) jobs and desired goods and services.

The housing bubble in the US (and in other countries too) might not have happened if people could have somehow "sold short" houses (which of course was/is impossible). When prices go too high (for anything)bad things happen, which becomes evident for all to see when prices inevitably come back down again.

Now that we can see that shortsellers help to prevent bubbles, or to end bubbles sooner than they otherwise would have ended, thus decreasing the pain, we can see that short sellers are actually heroes of capitalism who help to direct scarce resources towards efficient uses, indirectly helping society in general in the process with new and better jobs, and new or cheaper or higher quality goods and services that people want or need. Not to mention prfits that are reinvested to do create more jobs and goods and services, as well as profits to be distributed to owners eventually who spend those dividends on goods and services that employed someone to create, or to invest in other companies, or to give away to the needy.

Not to mention all the taxes paid by corporate income taxes, payroll taxes, income taxes, consumption taxes, capital gains taxes, and dividend taxes that otherwise wouldn't have happened. This means either lower tax rates for everyone else, or more government spending, or reduced government debt, or some combination of the above.

Since *profitable* shortsellers are heroes, then people who try to ban them are villains, whether they realize it or not.

6:52 AM  
Blogger stefankarlsson said...

Newson, futures trading is not the same as short-selling, so that chart has little relevance for this discussion.

And while it is true that short-sellers will buy them back in the future, a future purchase has no effect on current prices, and at any given time short-selling will mean that the supply of securities today is greater. And a greater supply means a lower price.

5:49 PM  
Blogger Arnold T said...

Markets are never what people think they are. Markets do NOT reflect fundamentals but rather simply reflect the feeling of what market participants feel. Reality be damned.

Now, short selling is detrimental for many reasons. Number one being an illogical fear capturing the market and driving prices down. Bank/Financial runs are an example that we have seen lately. Without the irrational fear, a few of our large institutions would have remained viable from a fundamental balance sheet prospective.

Second is profiteering due to the feeding frenzy. Other big financial concerns actually shorted failing financial simply to make a quick profit due to the fear factor engulfing a financial stock.

Traders who understand the opportunities will short a market strictly on the assumption that fear is running wild and profits can be had from the chaos that ensues.

11:15 PM  
Blogger crmd said...

If short selling makes the market more efficient, should it therefore be allowed? Betting against the success of another person's business is immoral. Bad things happen when ethics are not considered; the market does not in a vaccuum.

12:24 AM  
Anonymous newson said...

stefan: the comparison between a cash market (onions post 1958), and a market with short-selling (onions pre-1958), is valid. whether it's futures or shares makes no difference (there are equity index futures, and futures over individual shares, as well).

short-selling increases liquidity and must necessarily lower volatility (fewer gaps on the chart, because of more regular profit-taking in both directions).

"This creates an asymmetric situation where people bullish about a stock will have much greater influence than those that are bearish about it, which increases the risk that some stocks will be over-valued."

- i agree, but this flies in the face of your assertion that short-selling may increase volatility. the more a stock becomes over-valued, the greater must be the eventual drop towards correct valuation. short-selling, as you point out, limits the size of this mispricing, so that the drops are less spectacular, because more frequent re-alignment occurs.

since covered short-sellers are paying daily interest on their bets, there will only maintain this position until the misvaluation-profits are matched by the holding costs of the exercise, very much a finite time. the future is not an unlimited one, when a position costs money to maintain.

you haven't addressed the naked shorts problem, which has brought short-selling into disrepute. this is case of contractual failure by the clearing house and wall st brokers, and is a fraud against shareholders.

2:20 AM  
Blogger Tom said...

"Banning short-selling delays price adjustment to the correct value."

That's a pretty astonishing two flaws in one tiny sentence!

1. Surely you need to prove such an absolute claim and not simply assert it?

2. Is "delaying price adjustment to the correct value" necessarily a bad thing?


It really isn't clear that short selling does increase liquidity.

In illiquid markets, only fools sell short, particularly uncovered shorts - and while this does sometimes happen, this seems to quickly be followed up by the traders who are long simply holding the security and waiting for the short squeeze - not good for liquidity and certainly not for efficient pricing.

But in already-liquid markets, the marginal liquidity that is added by the short seller appears to be small. While it's difficult to tell from examples when short sales are banned (because spreads will naturally be wider because of market uncertainty), it certainly seems that when short selling is enabled on a security, there is or no change to the spreads.

As to "delaying price adjustment to the correct value", I think we'd all agree that this would be a bad thing if the delay were years or months. In the case of short selling vs no short selling, we're talking minutes of delay if that.

Frankly, I can only see that as a good thing. Perhaps some floor trader will make a little less, some investor a little more, but a temporary ban on short selling, particularly uncovered short selling, is a rational, equitable idea that encourages rational, relaxed price discovery and discourages these hysterical, irrational panics that clearly cause far more harm to liquidity than any short-selling ban could ever do.

2:32 AM  
Blogger Tom said...

"To make a long story "short", shortsellers, if they are profitable then they helped bring the stock price down to a level that more correctly reflects the company's fundamentals. In so doing, these short sellers on a stock by stock basis help prevent entrepreneurs from starting companies in fields where new supply isn't needed. Instead entrepreneurs start up somewhere else that looks more profitable, thus benefitting society by creating sustainable (i.e. profitable) jobs and desired goods and services."

Dreadful, dreadful argument.

You are completely ignoring the massive difference in time scales between short sellers and people constructing a business.

If you believe in efficient markets, short sellers aren't setting the price - they're simply providing more liquidity and allowing the market to more quickly find its natural price level.

But short sellers think in terms of days and weeks; people starting a business think in terms of years and the activities of short sellers are simply not significant to them.

If I were to start an auto business now, I wouldn't look at Ford's price today - I'd be relying on estimates of the world two to five years down the line.

And it's really not at all clear that the market provides such clear information for the entrepreneur anyway - if Ford's stock drops, does that mean, "My competitor is weakening, I should go ahead," or, "The car market is doing badly, I should give up"?

Sure, there's some neatness in having stock prices adjust in minutes rather than hours or days, but really very little actual utility. Only fools plan their businesses around the hour's stock market figures.

2:48 AM  
Blogger Tom said...

we can see that short sellers are actually heroes of capitalism

No, they're actually individuals attempting to increase their net worth without actually producing any good or service of value.

If these markets you speak of are truly so "efficient" then how come such huge amounts of money ends up in the hands of the financiers and speculators?

In an "efficient" market, surely the cost of the financing and liquidity activities would be brought to such a level that it was barely worth people's time to participate in it? ("Where are the customer's yachts?")

America needs to learn that you cannot create value by shuffling paper around. I can't believe it's November 2009 and you haven't learned that lesson yet.

All this trading cannot create real value. It can sometimes reveal real value that was hidden, but it's 20 years after leveraged buyouts and Drexel (my first Wall Street firm, btw, I wrote option models for them) and all the plums hidden on Wall Street have long since been picked and eaten.

3:01 AM  
Blogger Jason said...

if short selling of securities is banned in the spot or physical market (like the ban in short selling of shares in USA, UK, and Australia) how do you think it would it impact the futures market for those securities?

8:17 AM  

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