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Why Ban Short-Selling?
So Europe – or at least France, Belgium, Italy or Spain – is banning naked short-selling. What exactly does that mean? And will it work?
Let’s just go through a quick definition: when you buy a stock, normally, it’s called going “long.” You’re betting that the stock will go up.
So what’s the opposite of long? Going short. When you want to bet a stock will go down in value, then you’re going short. You do that by borrowing the stock at a certain price from a stockbroker – say at $10, usually with a cash deposit – then waiting until the value goes down to about $8, and selling the stock back to the broker. That $2 is profit.
Naked short-selling is going short without first borrowing it. The naked shorts agree to borrow the stock – but they go ahead and use it to bet before it’s actually delivered, so they aren’t actually taking the risk of holding the stock.
Naturally, there are people who oppose the move in Europe. EDHEC, a French business school, today released a long statement opposing the short-selling move. They plan to take their opposition to France’s AutoritÃ© des marchÃ©s financiers (their equivalent of the SEC) as well as to other European financial-market regulators. I asked Ekkehart Boehmer, a professor at the EDHEC Business School, on whether there are any specific mechanisms we can put in the market to prevent panic selling from taking a stock or an industry down. Here is what he wrote to me in an email:
Panic selling usually refers to selling that is not justified by negative fundamental information, but rather caused by fear of further price declines. This fear could arise is traders believe that OTHER traders will continue selling regardless of fundamentals.
This will then cause other traders to sell too, further depressing prices, and further increasing fear. If this happens, this circle needs to be interrupted. Regulators’ logic is that it can be interrupted by forcing traders to pause for a certain period – hence the “circuit breakers” that many countries including the US have.
They kick in after predefined price declines and pause trading for minutes, hours, or the rest of the day, depending on the rule. There are similar rules now in the US that make short selling harder when prices decline.
But these circuit breakers are also problematic – imagine you could sell your house today for 400K but the regulator tells you that the market is closed for the month. When it reopens, you find your house now trades at 100K.
The point is that prices usually adjust anyway – it didn’t help the Moscow stock exchange to shut down for several days during the 2008 crash. Prices fell anyway. Similarly, there was the Flash Crash in 2010 – perhaps a circuit breaker could have avoided the blip. But after all the market fixed it itself, and perhaps a circuit breaker would have made things worse.
So bottom line, there are ways to limit “panic selling” but it is not clear whether it is desirable to do so – traders who want to sell are hurt. Why should regulators advantage buyers over sellers? Moreover, it is hard to assess even after the fact whether circuit breakers are really helpful or harmful. Academic research too is fairly inconclusive on the issue.
As Boehmer points out, there are a few problems with bans on short-selling.
The most important is that it doesn’t conclusively work; and if the market wants to turn against a stock – with or without reason – history has shown that it will do it anyway.
Back in 2008, the United States also imposed a ban on naked short-selling. Its effectiveness was questionable, as I wrote about at the time. For instance, note that it didn’t stop Lehman Brothers, Morgan Stanley or Goldman Sachs from getting deeply hit just a month later, or Fannie Mae and Freddie Mac from eventually coming under government control. In many ways, the short-selling ban was like the security blanket that Linus, from the Peanuts cartoons, carried around with him: it provides psychological comfort, but you can’t lock the outside world out forever.
For instance, even the ban on naked-short-selling hasn’t prevented shares of France’s Societe Generale from dipping again today on more rumors. And our friends at FT Alphaville have some nice data showing that the problem with the stock-price dips in Europe is not short-selling. It’s the people who already own the stock – who are long – who are selling because of a sense of worry.
A ban also can’t last forever. A government can’t plausibly put a ban on any kind of short-selling into effect forever – especially if you want the market to reflect negative opinions on companies, not just the positive ones. It’s not surprising when finance professionals object that “La la la la, I can’t hear you” is not a plausible market mechanism.
So what does work? The answer that satisfies EDHEC may not satisfy everyone. One of their spokesmen, Frederic Ducoloumbier, told me over e-mail that the only thing that may stop panic-selling is addressing the fundamentals:
“tampering with market mechanisms and changing the rules of the game could at best buy time, and the best way to address fears and doubts in the context of the current crisis was through more transparency on the part of the financial institutions and (much) stronger political leadership.”
In a long history of panics, however, it’s not clear that anything can really stop them. The most we can hope for is that we have ways of containing the damage. And that’s very difficult to do.