The Short Selling Ban

A number of European countries decided to ban short selling for a period of 15 days and the light of introspection deserves to be thrown upon what these measures actually mean for the functioning of global financial markets. It is understandable that Governments should be concerned about the downward spiral in stock prices because they do have a direct effect on the economy. For example, lower equity markets affect shareholders net worth and their propensity to consume. In addition, low equity values will affect companies’ abilities to raise cash and, particularly, banks balance sheets.

Short Selling and Hedge Funds

All of the above is a concern, so stopping shorting can be seen in a positive light, particularly when long only investors are facing losses and, all manner of pejorative language is being used against the ‘evil’ short sellers. The common perception of short selling is of an art practiced in the ‘shady’ and lightly regulated world of hedge funds.

 ‘Shorters’ are seen as short term speculators who are preying on the misfortunes of others, and some are even seen as promulgators of false rumours and media speculation around their targets. This negative perception has hardly been helped by the criminal activities of Madoff and Rajaratnam. Moreover, the ludicrous amounts of money that some hedge fund managers earn is an easy target for criticism from the tabloid press.

Why Banning Short Selling is Wrong

The principle arguments against banning short selling are that it is not really efficacious (it did little to stop banking stocks sliding in the financial crisis of 2008) and, that it helps to create inefficiently priced stocks. Both of these points make perfect sense and the importance of pricing signals in a market economy should never be underestimated, but there is a deeper, more important, reason why shorting should not be banned.  Simply put, shorting creates the opportunity for myriad and diversified investment strategies which help to hedge risk away. However, this argument should not be restricted to investment strategies on a micro-economic level. Its true import is related to the global economy!

Increasing Globalisation and Correlation in the Global Economy

Essentially, the problems of the financial last few years have been created by a World that is becoming increasingly interlinked and whose asset classes and economies are synchronised to such a degree that economic cycles are creating super-positional peaks and troughs. In plain English, this means that if all the economies are dependent on one variable (ex mortgage bonds on banks’ balance sheets) then the potential for disaster is that much larger.

Moreover, these risks tend to be directional because vested interests snowball to create these scenarios. For example, banks start issuing sub-prime debt to NINJA’s (no income no job), then structuring CDO’s, other banks buy the debt, and suddenly everyone (homeowners, banks, politicians, bank debtors) becomes reliant upon the debt not collapsing. The rest is history. Unfortunately, the economic consequences are not. 

How Short Selling Helps Markets

The one caveat to the above scenario is if some economic agents are diversified in the direction of their profitability. So, for example, if there had been significant numbers of banks who had been short sub-prime mortgages or had diversified away from this directional risk then they would have able to buy up the failing banks or at least support the underlying assets. The banks were very vocal in criticising the necessity of marking their assets to market during the financial crash, but the real problem was that none of them had the financial position to buy these assets of each other. This is what happens when all the financial institutions profitability is dependent upon the same direction. Increased correlation intensifies systemic risk, whilst diversification helps to mitigate it.

If the authorities persist in trying to ban short selling all they will, de-facto, be doing is encouraging more correlation of asset classes and interests. This is likely to create more risk and stop –at source- the nascence of diversified strategies that should be seen as helping, not hindering, global growth.