Did short selling in the stock market strengthen recent market volatility?
Introduction
Several factors, it has been claimed, have aggravated the current volatility in the markets. These factors include the discounted price of money, which led to an excessive flow of money in the market, the failure to correctly price assets that were traded and correctly assess the ability of borrowers (or mortgage owners) to pay back their loans. Other components, such as short selling, was also said (by many financial institutions) to have strengthened this crisis.
This paper assesses the veracity of this statement. It firstly outlines the definition of short selling and continues by discussing both sides of the argument (i. e. whether short selling is an exercise that should be eradicated from the functioning of the markets or not) and concludes by giving the author’s opinion on the discussion.
Many of the firms that found themselves in financial difficulty incriminated short selling for worsening their instability in the market. In particular, Lehman Brothers Holdings Chief Executive Richard Fuld pointed out before Congress on October 6th that naked short selling is one of the guilty parties in the September 15th bankruptcy of the firm. He also referred to short selling as an invitation to market manipulation.
Definition of short selling
Platt, H (2008) describes short sellers as ”Speculators who sell securities that they do not own but which they borrow from their owners”. Speculators perform in this manner because they believe that the stock is overpriced and consequently it is expected to fall in value. Short selling is an exercise that does not carry risks in itself since it is fully collateralised. Such activity has an impact on the underlying shares’ price.
Example of short selling
To short sell a stock in a given company, an agent (A) must find a supplier (B) who owns and is able and willing to loan the shares of this given company. After the loan is settled, agent A can now sell the shares to a willing buyer (C). Indeed, for the lender to give away its shares, the short seller must leave a guarantee (or collateral) with lender (usually equal to 102% of the market value of the stock, a proportion in financial vehicles such as bonds and equities and the remaining in cash). In return, the lender pays a ‘rebate’ for using the cash collateral.
Naked short selling
Naked short selling differs from the normal short selling activity in that the short seller does not firstly borrow the shares. In fact, the seller enters a short position before borrowing the shares. Once the position is settled, the borrower must find a willing lender to execute his (her) position. Certainly, this may lead to default in the transaction if a lender cannot be found within the required time. Naked short selling could be intentionally used to avoid strict constraints on short selling. In fact, if no loans have been made, neither tax nor interest rate can be charged on it. Thus, this could help the short seller to reduce the cost of acquiring the shares in the first place. (Culp, C and Heaton, J: 2007)
Most shares traded on major stock exchanges are shortable as Edwards, A and Hanley, K (2008) demonstrated in their paper. Most short selling activities are conducted by organisations such as hedge funds, pension funds and insurance companies. Short selling is among many of the strategies used by these institutions to manage their assets or portfolios. However, an increase in the use of this activity could impact the value of the underlying shares. Indeed, if the supply of a particular share goes up, its price tends to fall to a new equilibrium point. In other words, if we observe an increase in the supply of a given share, its price would adjust accordingly to meet the new level of supply. For instance, if the fair price of Barclays bank is 400 pence, and it is found that the supply of its shares on the equity market is increasing, this would lead to a decrease in price (the decline may depend on the incremental number of supply). More and more investors began to sell short after the credit crisis fired up, trying to make a profit from the oncoming decrease in shares’ value. One may say that short selling did not help the shares keep their ‘true’ value during the catastrophe, but can it be blamed for worsening the current crisis?
Arguments against Short Selling
Some may argue that short selling is not a safe and sound activity in the stock market, particularly naked short selling. In actual fact, naked short selling exposes companies’ shares in the sense that the transaction is recorded in the market whilst physical borrowing has not been arranged yet. Hence, there is no guarantee that the short seller will effectively be able to borrow the shares and sell them.
To solve this inadequacy in the market, several authorities and commissions such as the SEC (Security and Exchange Commission) in the US has temporarily ended short selling of the financial stocks of a few companies to protect investors and markets (www.sec.gov: 2008). This action was taken on September 19th, 2008 for main purpose of reducing manipulation that endangers investors and capital markets. The FSA (Financial Service Authority) also released in the same month ”new provisions to the Code of Market Conduct to prohibit the active creation or increase of net short positions in publicly quoted financial companies” (www.fsa.gov.uk : 2008). Both actions taken by the SEC and the FSA are provisional and are likely to only be in practice during the current market instability. These actions relieved some companies and helped a number of bank stock prices to rise after the regulations on short selling came into force.
The incentive behind short selling could be what is detrimental. In fact, some short selling activities within companies are not undertaken in the aim of investors’ interests. A recent example of this is the naked short selling activities engaged in by Goldman Sachs Group Inc. This global bank holding company was accused of acting against its clients by trying to profit (from naked short selling activities) at their expense. Many suggestions have been put forward trying to improve short selling activities in the market. One of these suggestions is the reinstitution of the ‘uptick test’, which requires that a share should only be sold short when its recent movement was up.
The application of restrictions on short selling (followed by the FSA new regulation in place) creates some conflict in the trading market. These interests could have three aspects: the markets, the companies (as entities raising money) and investors (as shareholders). In fact, a decrease in short selling activities could lead to the underpinning markets lagging behind competition, which could move international investors away from those markets to more efficient and liquid markets. On the other hand, a market with less short selling could also be attractive to investors given that that market is regarded as a low risk market (these two statements would depends upon how much risk investors are prepared to take on. In other words whether we are faced with passive or active investors.) Furthermore, while short selling may affect companies’ assets, it helps investors to fairly valuate shares. Whilst short selling may have some negative impact in critical market conditions, it is also considered to be a valuable tool in financial markets. One could say that short sellers have contributed to the current crisis, as better market confidence and share price rises have been observed in the markets after the short selling ban from the FSA.
Arguments for Short Selling
According to Bris, A et al (2003), over 95% of securities on the equity market are shortable. This may have contributed to the efficiency in the market up until recently, when the market became volatile. As Curtis, A and Fargher, N (2008) affirmed in their paper, short sellers help stock prices reflect their true price in accordance with fundamental value; and that they do not increase unjustifiable price declines. Bai, L (2007) also found that the volume of short selling in the market conditioned with the ‘uptick’ rule and in the market without the uptick rule was similar. They also found that the price decline was not decreasing at a lower rate in a constrained market compared to the price decline in a ‘normal market’. This could imply that short selling activities do not influence as such stock prices.
Short selling helps maintain efficiency in markets (Bris, A, Goetzmann, W and Zhu, N (2003). In fact, it helps to fairly determine the price of shares since the motivation behind selling stocks could be due to its forecasted fall in value. Short selling helps liquidity in the markets. Liquidity could be defined as ‘the ability to trade a large number of securities quickly and at low cost’ (Lhabitant, F and Gregoriou, G: 2008). Liquidity is a one of the major characteristics of an efficient market inasmuch as it allows investors to convert or liquidate their holding assets. Makinson Cowell (2005) observed in his paper that for FTSE 100 companies in the UK the average percentage of firms’ shares on loan in the market has increased from 3% in late 2003 to over 5% by late 2005.This increase in loans helped liquidity in the markets.
Short selling could be seen as one of the normal strategies used to manage investments. Indeed, typical investors would dispose of the shares they expect to fall in price, since these shares are likely to contribute to a decline in the value of their overall investment. Others may argue that short sellers are not the cause of the fall in stock prices and they may only be entitled to a limited influence of this price fall. Doubtlessly, if adverse information is disclosed in the market which would somehow affect a particular type of shares, whether or not short sellers enter the market, it will not make much difference. As Bill Fleckenstein (from Fleckenstein Capital) asserted in one of his articlest: “Investors who bet that stocks will decline, as short sellers do, are simply bears. And that they are not to blame for the market meltdown”. Daske, H, Richardson, S and Tuna, I (2005) demonstrated in their paper that there was no verification that short sale transactions are agglomerated prior to bad news events. Their results were based on empirical data up to 2004. However, their findings conflicted with some past research (such as Diether, K, Lee, K and Werner, I: 2007 ) where they found that in the New York Stock Exchange, short sellers can correctly predict future returns and make profits from this activity.
Although short selling during the crisis may have participated to the fall in the value of the shares (because of some overreaction of investors), it has helped the shares to reflect their true value. This, of course, was not promising for companies but on the other hand, it has helped short sellers to get rid of their ‘toxic’ assets. Some markets are constructed in a way that does not favour short selling activities. There are some factors such as taxes and regulations that make some short selling more desirable than others (Bris, A et al: 2003). For example, markets where lending is less taxable would be preferred for short selling activities compared to others. Diether, K, Lee, K and Werner, I (2007) suggested in their article that ‘the costs of borrowing stocks for short-sales are not constraining US short-sellers significantly.’
Conclusion
Short selling could be seen as a strategy used by investors to manage their investment. Short selling does not usually represent a threat in a good working and efficient market. However, it may be manipulated in markets in distress, therefore exposing companies and investors. If we were to look at the companies’ side of the story, short selling is detrimental since it exposes their shares to excessive drop in price, but observing from the shareholder’s aspect, it facilitates liquidity and the price determination of shares.
Although measures have been taken by national authorities to eradicate this problem, a major improvement has not been observed in the market relating to this aspect. This could be a replica of the Asian currency crisis of 1997, where, despite all measures taken against short selling, they did not fully help prices to return to their original value. It could be difficult to assess the issue of short selling since they are not all exercised on an open market and are not all disclosed for public information. Disclosures of short selling activities by companies may help national authorities to better tackle the problem.
References:
Bai, L (2007) ‘THE UPTICK RULE OF SHORT SALE REGULATION – CAN IT ALLEVIATE THE DOWNWARD PRESSURE FROM NEGATIVE EARNINGS SHOCKS?’ [Online] Available from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=956106 [13th Nov 2008]
Bris, A, Goetzmann, W and Zhu, N (2003) ‘SHORT-SALES IN GLOBAL PERSPECTIVE’ [Online] Available from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=486264 [7th Nov 2008]
Culp, C and Heaton, J (2007) ‘Naked Shorting’ [Online] Available from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=982898&download=yes
Curtis, A and Fargher, N (2008) ‘Does short-selling amplify price declines or align stocks with their fundamental values?’ [Online] Available from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=817446 [14th Nov 2008]
Daske, H, Richardson, S and Tuna, I (2005) ‘Do short sale transactions precede bad news events?’ [Online] Available from http://papers.ssrn.com/sol3/results.cfm
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Lhabitant, F and Gregoriou, G (2008) ‘Stock Market Liquidity: Implications for Market Microstructure and Asset Pricing.’ Wiley, New York
FUld, R (2008) ‘Statement of Richard S. Fuld, JR before the United States of Representatives Committee on oversight and Government Reform’[Online] Available from http://online.wsj.com/public/resources/documents/fuldtestimony20081006.pdf
FSA. Gov (2008) ‘FSA statement on Short Positions in Financial Stocks’ [Online] Available from http://www.fsa.gov.uk/pages/Library/Communication/PR/2008/102.shtml
[15th Nov 2008]
Paulden, P and Salas, C (2008) ‘Goldman Targeted by Investor Complaints of Naked Short-Selling’ [Online] Available from http://www.bloomberg.com/apps/news?pid=20601087&sid=as3PwfEfBlhk&refer=home [17th Nov 2008]
U.S. Security and Exchange Commission (2008) ‘SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets’ [Online] Available from http://www.sec.gov/news/press/2008/2008-211.htm [15th Nov 2008]