Short selling financial stocks

“Most of the developed world has moved in the past two weeks to impose temporary restrictions on shorting – or betting against – the shares of banks and insurers, with some extending the bans far wider. ....

[I]t has become received wisdom in the popular media that the failure of banks was the fault of short sellers, whom John Sentamu, archbishop of York, called "bank robbers and asset strippers". ....

Yet shorting is not a shady practice used only in dark corners of the City of London and Wall Street. It is core to the functioning of efficient financial markets. According to academics, it makes prices more accurate ....

Whether or not to exempt certain types of short selling comes down to the concept of "good" versus "bad" shorting. Indeed, the Church of England makes this distinction itself in defending its use of currency hedging for its vast investment portfolio, a practice that could be described as shorting entire countries.

But the unintended consequences of banning shorting in financial stocks make clear that this distinction is hard to draw. Aside from convertibles, the biggest impact is on liquidity in the market – the ease with which shares can be bought and sold.

According to Credit Suisse, the cost of trading rose sharply in stocks that can no longer be shorted, as bid-offer spreads – the difference between buying and selling prices at any moment – widened "substantially". The reason was simple: volume plunged as hedge funds stopped taking long positions that they could not hedge with short positions in other stocks.”

James Mackintosh, "Short shrift", Financial Times (6 October 2008).

http://www.ft.com/cms/s/0/f8328a36-92fc-11dd-98b5-0000779fd18c.html


James Mackintosh writes for the Financial Times of London.

Short selling stocks is the practice of selling a security such as corporate stock that you do not own and selling it for future delivery. Between the time that you sell it and the time that you must deliver the stock, you hope the price will fall so that you can make a profit on the sale. Of course, things can go wrong. Rather than the price of the stock you do not have and must deliver falling, it could rise, and the short seller suffers a loss by having to pay more for the stock than the price at which he sold it. Needless to say, short selling should not be practiced by the faith of heart.

The question is whether short selling is good for the market. Because short sellers are not making decisions on the basis of any assessment of the prospects of the firm or its fundamental they are seen by some as adding volatility and instability to the market. Others point to the fact they add liquidity, that is, they make it easier to buy and sell securities. Some say they take advantage of the misfortune of others. Theorists, on the other hand, say they are important to the price setting and determination mechanism. The debate about short selling continues.

To my knowledge, academic research about short selling tends to support its usefulness but the question is far from settled.

The article by Mackintosh begins with the following humorous question about those that engage in short selling:

“What do you say to a hedge fund manager who can’t hedge? ‘Quarter pounder and fries, please.’”

Thanks once again to Larry Willmore for the Tdj.