A number of countries have introduced short-selling restrictions today. This is a classic tactic in bear markets. Back in 2002, I wrote a paper analysing in some detail the economic role of short-selling and the impact of various proposed regulatory restrictions upon it. It’s worth observing the following points, in the light of today’s events:
1. Companies and countries complain about “damaging speculators” when they are selling, but not about speculative buying (which is just as common). Yet in economic terms, going “long” – e.g. having positive holdings of shares – is just as much a form of speculation as going “short” – e.g. having negative holdings (i.e. has sold shares one does not yet own). Indeed, some forms of short-term speculative “long” positions can be thought of as being “short” in cash.
2. Outside financial circles, in real economy businesses, short-selling is commonplace and uncontroversial. If a plastic resin manufacturer takes a pre-paid order to supply a plastic bottle manufacturer with resin in a month’s time, it has gone “short” that much plastic. Is that wicked speculation?
3. In financial markets, speculators make money by being better informed than other participants, so they see opportunities to make money when other participants catch up and prices move. It is highly desirable that market players should be able to make money by analysing data so as to get ahead of the Market. Curtailing that has the effect of making market prices less reflective of how the world really is – they become less “efficient”, in the jargon. Virtually no one is going to analyse data if there is no money to be made by doing so, because proper analysis is difficult and expensive.
4. Short-sellers make money by identifying situations in which the world is worse than the Market thinks. They expose cases where managements or governments are disorganised or lying or have themselves been deceived. Given the events of the past few years, it would seem very foolish to try to deter people from properly analysing companies or governments to see whether they might actually be less robust than they claim. Surely we want more such analysis, not less!
5. In developed economy markets, volumes are vastly beyond the level at which speculators can move prices “artificially” by the volumes of their trades. Price movements reflect changes in opinions. There is no such thing as speculative “attack”, in that sense.
6. However, once we understand that analysis is costly, and market players differ in their analytical skills and specialisms, it is inevitable that many market players will not carry out their own analysis, but, instead, follow the trades of those they consider better informed.
7. Because markets inevitably have this follower-leader structure, that means that those that are better informed will be able to move prices sometimes, even if they do not actually know anything – they can create “uninformative volatility”. That is to say, it is an inevitable feature of financial markets that not all price movements reflect genuine new information or new analysis. (Note: my claim here is completely orthodox – this is the standard theory, not some “irrationality” claim or rejection of efficient markets theory (in its standard “weak” form). Real nerds might look at this classic paper, in which the orthodox position is set out.)
8. The more regularly speculators are moving markets without actually knowing anything better, the less they will move markets, and vice versa.
9.Even though better-informed speculators do generate uninformative volatility, their net effect is to increase the informedness of prices. That is to say, markets are (much) more efficient when speculation is permitted than when it is forbidden.
10. There is, however, a caveat to all this. The flawed way in which bank prudential regulation works creates a discontinuity – i.e. sudden change. If bank capital, as measured by regulators in particular ways that include consideration of market share prices, falls below the regulatory threshold, regulators might respond by intervening in the bank - perhaps by shutting it down or even by nationalising it. That could cause the bank’s shares to lose further value. So once a bank’s capital comes close to the threshold, the bank becomes vulnerable to short-sellers that might often actually be better informed moving prices, just enough, to drive it below regulatory thresholds, triggering intervention and a collapse in its share prices. These short-sellers can then clean up. This can make short-selling under these circumstances close to self-fulfilling – the short-sellers can exploit the flaw in the regulation.
Personally, I would recommend improving the prudential regulation to correct the flaw. But it is understandable that regulators unwilling to engage in this wider task prefer instead to adopt the short-term expedient of banning short-selling once bank share prices get close to the danger level. Doing so can even create a quick bounce, as other short-sellers are “squeezed” (i.e. have to buy out of their short positions quickly, bidding up prices meaning they make big losses).
Overall, then, short-selling (and other forms of speculation) are extremely valuable. They improve market efficiency (as well as liquidity – for reasons I don’t have space to explore here) and they expose errors made by the management of companies and by governments, early, when those companies and governments might still have a chance to rectify things. Banning short-selling is a classic case of shooting the messenger because one does not like the truth he tells. But unfortunately, bank prudential regulation is flawed and a number of European banks are at risk – as Col Jessep might have said, were he a financial regulator, “You can’t handle the truth“.