Jeremy Warner: America moves in on short sellers
Thursday 12 March 2009
Outlook It's the way with regulators. With perfect timing in July 2007 as the bull market was reaching its zenith, the US Securities & Exchange Commission abandoned the "uptick" rule, a measure originally introduced as far back as the Great Depression to limit the supposedly damaging consequences of speculative short selling.
There followed a veritable orgy of short selling, particularly of bank stocks and other financials, the like of which the world has never seen before. Now, with the damage done and the short-selling splurge having largely run its course, the SEC is thinking of reintroducing the uptick rule afresh.
The SEC thus conforms to a familiar pattern: deregulate just when markets need to be hemmed in most and then, after the horse has bolted, pile it all back on again. In truth, this is the point at which markets need it least. The salutary lessons of the last bust will make them well-behaved of their own accord for years to come. Hey ho.
The best defence of "shorting" – or selling shares you do not actually own in the hope of turning a profit by later buying them back at a lower price – is that it improves liquidity, the speed of price discovery, and therefore the efficiency of capital allocation.
Yet in unstable conditions, it can also help provoke capital-destructive market panics. Negative rumour-mongering and analysis in combination with heavy shorting have greatly contributed to the banking crisis by undermining confidence and causing depositors and investors to retreat to safe havens.
The fact that short-selling hedge funds have turned out eventually to be right about the banks is neither here nor there. Banking is all about confidence. By helping to trash it, shorting has accelerated, or even helped cause, the failure of banks and the need for hundreds of billions of pounds in bailouts from taxpayers. Never before have short-selling speculators succeeded in so profitably creating such a gigantic self-fulfilling prophecy.
Apologists will argue that it was market fundamentals – too much leverage in conjunction with overvalued companies which had failed to prepare for bad times – rather than shorting that drove stock prices down. Yet it is hard to believe prices got so low simply because traditional long holders got out of their positions.
The purpose of stock markets is to put those who need capital in touch with those who can provide it, and, by allowing shares to be freely traded, supply a mechanism for pricing equity risk. Shorting fulfils no obvious part of this function. The sustained selling pressure it generates is entirely artificial in nature, in that shorters don't actually own the stock they are selling.
Personally, I cannot see the harm in reintroducing the "uptick" rule, which doesn't attempt to ban short selling outright, but only to limit its self-fulfilling attributes by preventing such trades unless a share price is moving up in value.
That's a deterrent, but it is not a prohibition, so it seems a reasonable compromise between the sometimes conflicting calls of financial freedom and well-ordered markets. If there's an uptick rule, it might be argued, why not also have a matching downtick rule to deal with the irrational exuberance of investors during a bull market? As we have discovered to our cost, stock-market bubbles can be just as harmful as crashes. The one leads inevitably to the other. Why not regulate the longs as well as the shorts?
Well maybe, but the point of regulation is to prevent the free-market system imploding at vast cost to the taxpayer as it has done over the last two years. Short selling has contributed to the collapse in confidence and the downward spiral in asset prices that lie at the heart of the crisis.
In that sense, the effect of shorting is not so dissimilar to mark-to-market accounting, which likewise has helped magnify and exaggerate the crisis by forcing recognition of temporary declines in asset values and therefore created problems of solvency and liquidity for banks and other financial institutions.
There's a big lobby in defence of shorting, a practice which has helped greatly to increase the volume of trading in shares in recent years and therefore the commissions that are earned from it. But does short trading really help profit the wider economy? It is hard to see how.
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