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Source link: http://archive.mises.org/6479/dont-sell-short-selling-short/

Don’t Sell Short Selling Short

April 6, 2007 by

Stockholders and managers of firms, whose interests lie in higher prices for what they own or manage, miss few opportunities to deride short sellers. Regulators, whose blunders short sellers frequently reveal by discovering fraud that escaped their attention, respond similarly. That combination of interests helps explain why, at various times, short selling has been banned in many countries, including England, France and Japan. And yet, to attack or restrict short selling is then to restrict the market’s ability to elicit and integrate all available information. FULL ARTICLE

{ 14 comments }

Person April 6, 2007 at 9:21 am

Good points in the article. One problem with short-selling, of course, is that if the market gets much *more* irrational, the short-seller may be forced to redeem his position, making it less effective than it could be. Here’s an idea I thought of to get around that: Allow people to short sell a stock by issuing their own “phantom shares” instead of borrowing existing ones. A phantom share is a promise by the issuer to pay dividends (or buyouts) in the precise amount that the real stock pays. They would clearly be labled as phantom shares, and could have lower collateral requirements. (e.g. the greater of 20x the last annual dividend or twice the sale price). The phantom shorter (or “phaser” for short) could eliminate his obligation at any time by buying real shares to replace the phantom ones.

The idea is that it could puncture “bubble” growth stocks. The real stock issuer could attack phasers by declaring big dividends, but if they can’t back them up, that could trigger a selloff due to the greater leverage. Thoughts?

Sorry for the ramble.

Mike Sproul April 6, 2007 at 9:28 am

Hi Gary:

All valid points, but don’t forget the problem of a guy who puts cyanide in Tylenol capsules and then goes short in the stock of the company that makes tylenol. There’s also the guy who goes short in airline stock just before crashing jets into the world trade center.

Gabriel April 6, 2007 at 11:57 am

don’t forget the problem of a guy who puts cyanide in Tylenol capsules and then goes short in the stock of the company that makes tylenol. There’s also the guy who goes short in airline stock just before crashing jets into the world trade center.

Those are indeed real problems. However, there is also the flip side: it is just as likely that a business owner/stockholder might try to increase business/stockprices by putting cyanide in their competitor’s capsules or by bribing the politicians to give their company an over-priced WTC reconstruction contract. In short, as far as I can tell, allowing short selling doesn’t increase the risk of force or fraud any more than simply allowing stock to be purchased or businesses to be opened.

tMoC April 6, 2007 at 1:55 pm

Mike: In the first case, the short-seller is setting himself up for scrutiny by a competent investigator. I assume the latter case is at least partially joking…

John Hall April 6, 2007 at 4:06 pm

The key point is that the person who knowingly puts cyanide in Tylenol and organizes planes to hit the WTC be prosecuted for destruction of property and murder. The question then becomes did the person also commit fraud by engaging in the transaction of either shorting the stock or buying a put option (or whatever strategy they use). For a libertarian perspective (though not what the regulator would do) I think this is a case similar to insider trading where no one is really harmed from the trading transaction. The bank that loans the shorter the shares receives their interest and would have performed the loan operation anyway. The person who buys their stock at the onset of the short is not compelled to do so and would have bought shares in the company anyway if the stock has decent volume. And obviously when he buys the shares back again, the person who sells him the stock would have sold it anyway. If he is buying a put option, the person on the other side of the trade would have wrote the put anyway if the stock is very liquid. However, I think an argument might be able to be made that there is some form of fraud on a futures contract, a swap, or an option when there is very low liquidity/volume of the stock and you might be dealing with the person more directly.

By the way, the people who shorted the airlines before 9/11 never collected the money from their options.

Scott S April 7, 2007 at 9:35 am

“Allow people to short sell a stock by issuing their own “phantom shares” instead of borrowing existing ones.”

That’s naked shorting and is equivalent to counterfeiting a stock certificate. And what if the issuer of the phantom shares goes bankrupt? Then what?

Scott S April 7, 2007 at 9:37 am

“They would clearly be labled as phantom shares”

Who in their right mind would knowingly buy these shares?

David White April 7, 2007 at 10:00 am

Here’s a terrific presentation on the prevalence of naked short selling and failure to deliver:

http://www.businessjive.com/nss/darkside.html

mike sproul April 7, 2007 at 10:38 am

“They would clearly be labled as phantom shares”

Who in their right mind would knowingly buy these shares?

They are called hypothecated shares, and one is created every time a short sale is executed. Investors accept them as long as they believe that the issuer has adequate collateral

Victor April 7, 2007 at 10:42 am

I remember reading an article, years ago, that one of the better predictors of a share price increase was a lot of “odd lot” short selling — in other words, small investors going short. More often than not, those odd lot short sellers were wrong.

In other words, plenty of short sellers lose money, because it’s just as hard to predict a price drop as a price rise. So there’s no reason for people to get huffy about short selling.

Bill, Risk Lover April 8, 2007 at 9:21 pm

Aside from the best argument to allow short selling: A person is free to use their money as they see fit. One of those uses is to bet against an asset increasing in value.

Short selling is good for a financial market. Short sellers punish under performers and force the asset owners to utilize them differently. The problem rarely lies in the investors but in the lies spun by the owners of the assets. They constantly pump up the prices. Short sellers seeing this come in and force the owners to satisfy their claims or see their asset values fall.

Bill, Risk Lover April 9, 2007 at 11:10 am

Short sellers force asset holders to justify the asset values. So they are very good lie detectors as the short sellers are risking something if their interpretation is incorrect. Regulators, police, accoutants, etc. do not have risk so they are poorer judges of the truth.

And as we know, most people do not like the truth, especially if they are not doing well or behaving badly.

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