There Is No Immorality In Going Short
Since the crisis of 2008, there has been a quite understandable rise in negative sentiment towards the behaviour of financial institutions. As I say, this is justified to an extent and, while I think works like The Big Short verge on hyperbole, one only has to recall the image of hedge fund managers sipping champagne on a balcony overlooking the Occupy Wall Street protests to remember that there has been some unsavoury behaviour in the industry.
It is this anger and hatred that has seemed to provide much of the motivation behind this, quite frankly, extraordinary week in US equity markets. The Reddit Wall Street Bets community were the instigators behind these market movements, and their logic was rather simple - hedge funds are vulnerable in a specific way, and if enough of us co-ordinate to move the prices of certain stocks we will be able to make them suffer. Beyond a general distrust and distaste for these institutions and the people who work for them, the particular behaviour of hedge funds that many seemed to single out was their practice of short selling. This is where these firms essentially make a bet that the price of an asset will go down in the future, and while not exclusive to hedge funds it is certainly a hallmark of their typical strategies.
In order to short a stock, an investor borrows the stock from another institution and sells it today. They must also post a fraction of the value of the stock as cash-collateral in a margin account. If the investor was correct and the stock price does go down at some point in the future, they buy the stock at the lower price and return it to the lender in order to earn a positive return. There is a famous quote from Daniel Drew, one of the richest Americans during the 19th century, which encapsulates this process:
"He who sells what isn't his'n, Must buy it back or go to prison" - Daniel Drew
There is therefore an inherent asymmetry between going long on a stock and going short in terms of how much risk an investor takes. To see this, consider the case where the short investor is incorrect, and the stock goes up. If this happens, the investor is faced with a choice - stay put and risk the price going up even more, or cover their position by buying the stock. They may also receive margin calls from the lender of the stocks in order to maintain their collateral value and if they can't meet these they will have no choice but to buy the stock. Since the price is unbounded above, the losses of the short-seller are also unboundedly large. This is different from an investor who goes long on a stock since in the worst-case scenario the price is bounded below at zero. However, by buying the stock the short-sellers unwittingly create additional demand for the stock and the price goes up even more, compounding the issue and potentially causing more short-sellers to have to cover their positions. This is a short squeeze and is exactly what we saw this week with GameStop, causing its stock price to increase by a staggering 19,355%.
A common reaction to these events, typified by the Elon Musk tweet below, has been to decry the morality of short-selling and make the claim that it is unethical for hedge funds to make what are essentially large bets on the failure of certain businesses. Many Reddit users claimed that their decision to choose to prop up GameStop was rooted in nostalgia towards bygone times when brick-and-mortar retailers were at the centre of the retail industry, and hedge funds should not be allowed to act as vultures picking on the corpses of these once-great companies.
This anger towards short-selling is nothing new. Periodically, the narrative of society and policymakers becomes hostile towards the strategy and decisions are taken to limit the practice. It is no surprise that Musk is no fan of shorting - Tesla has been the most shorted US stock for a while now, despite this leading to losses of over $39 billion in 2020.
During the Financial Crisis, most regulators around the world took the decision to impose short-selling bans. The logic behind this seems quite simple - if stocks are crashing then disallowing investors to bet against further declines should help to support prices, right? Wrong, or at least according to a 2013 paper by Alessandro Beber and Marco Pagano, who found that these bans did not help to prop up prices and had two actively detrimental consequences. Firstly, they resulted in a deterioration of liquidity in the form of widening bid-ask spreads - an undesirable property of any market and a sign of inefficiency. This was particularly bad, as investors would have found a liquid equity market particularly valuable in the face of illiquid bond markets. Secondly, they reduced the speed of price discovery in asset markets. By restricting traders from going short, the ban prevents investors with negative information about an asset from trading and as a result, the asset price does not incorporate this information in an expedient manner - another inefficient market characteristic.
To understand this in a different way, imagine if restrictions were placed on betting the under in sports betting markets (i.e. betting the under on how many touchdowns a quarterback will throw during the course of a game). This is essentially a short on that player. Would the odds price that emerged in equilibrium be an efficient one? Almost certainly not, as bettors who had negative information about the player would not be able to trade and this information would not be incorporated in the odds. This is bad for both parties, bettor and bookmaker.
While the general anger towards hedge funds is somewhat understandable, lashing out against short-selling only leads to less efficient capital markets which does not benefit anyone. In fact, I think there is a strong argument to be made that regulation should change to make shorting assets easier rather than harder. In 2008 and the years prior, the problem was not a surplus of short-sellers but rather a deficiency. If more people had been shorting Lehman Brothers, for example, more investors would have been aware of the firm's serious problems sooner and perhaps the disastrous fire sale which resulted when this information did come to light could have been avoided. Bubbles are clearly a significant problem for our financial system, and a natural remedy is to remove barriers towards making long-term bets against them as the characters in The Big Short did, with a lot of difficulties, against the US housing bubble. As such, it is important that policymakers do not bow to the rhetoric of people such as Musk (who are acting just as much in their own self-interest as hedge fund managers) and keep short-selling unhampered.