Should Short-Selling Be Limited?

I criticized Barack Obama's call to go after market manipulators like those rumored to have brought down Bear Stearns last month. My contention was that stricter enforcement could have a chilling effect on the dispersal of good information. But regulators seem to be taking the issue seriously. In congressional testimony earlier this month, S.E.C. boss Chris Cox strongly implied that the agency was looking into the Bear matter.

And Knowledge @ Wharton now points us to some recent research which argues that "bear raids" can cause real economic, not just financial, harm.

Itay Goldstein of Wharton and Alexander Guembel of Oxford look at a hypothetical situation where a company is looking to invest in a project with an outcome that is unknown. In a world where investors have special information about the potential payoff from the project, then if we see the stock price rise after the announcement, we have a good idea that the outlook is good. On the other hand, a price decline means that the project is probably a bad idea.

But in the real world, there are investors who don't have any special knowledge about such projects. If they chose to buy the stock on this non-information and the project turns out to be a bust, then investors lose out.

However, if investors start shorting the stock on no information and the stock declines, the company may read this as a sign that they shouldn't take on the project, even though it would ultimately have been profitable.

"On average, this is the wrong decision and will in itself reduce the value of the firm," the authors write. "This enables the speculator to cover his short position at a lower cost and make a profit. Due to the nature of this strategy, we refer to it as manipulation."

Of course, it's important that no one know what the speculator is up to, Goldstein says. "If everyone in the market knows that this hedge fund is trying to manipulate [the stock], then it will have no effect." It is essential, he adds, that the market's other players think the manipulator bases his decisions on insight even if he does not.

(emphasis mine)

The authors argue that regulations aimed at stifling incentives for manipulation through short-selling can improve market efficiency.

The S.E.C. already has some restrictions against selling short, but Goldestin and Guembel's analysis implies that further tightening may be needed. This can only be music to Patrick Byrne's ears.

Comments

[phdinsuntanning]

speculation has no impact in the long term performance of any business, according to a lot of cademic research and also common sense, you are not playing to be there forever, so maybe a little bit of volatility when cost of capital is low as it is now

[cehcvs]

Short selling just provides fuel for future rallies. When told that some were shorting Berkshire Hathaway, Warren Buffett said thats fine, and that he would be happy to lend shares to the short sellers.

[globalmacro]

Check out SPWR and STP at 2pm today. Good example of very odd market manipulation type stuff going on. No news and huge sudden declines.

[s.frankola]

Uh, Global... SPWR's conference call was taking place at 1:30. I don't know what was said, but I'm assuming that's why it went down.

And I liked it! I had 85 calls that I thought would surely expire worthless... got to cash out at $2!

[ari5000]

When a stock like CALM can be on the Naked Short List for 55 days with no consequences -- clearly regulation is needed.

Everyone should play by the same rules. Even if you knew a stock was going to zero -- and all the shares are short -- no one should be able to create phantom shares to drive the stock to zero. If so -- someone with enough capital could easily choose to destroy a company by limiting its access to additional funding.

It's not the biggest problem in the world but I think the SEC should at least enforce its own rules. That would be a nice start. But I won't hold my breath.

[stfeet]

Let 10,000 ETF/regular shorts bloom. This is a marginal piracy in comparison to the greater scope, Have at!

[thel337]

Forget the shorts someone needs to regulate Heli-Ben. He has massively manipulated the market as of late.

[BSCLossMan]

I'm no expert, and most people who read this SeekingAlpha site and many other investment sites won't agree with me, but in my ideal world I'd ban all puts, calls, options of all kinds, and all short-selling. Also, I'd ban all pre-market sales and post-market sales. In addition, I would ban all sales of stocks at discount prices (WU, et al). Everyone should always be on the same playing field. On the other hand, I'm willing (nice of me, huh?) to allow all this game playing to go on if everyone, including the Fed, would rename the stock market and all the various exchanges, with "casino" in the name. That's all the stock market has become, a big casino. No different than betting on horses.

[JJTERRITO]

Naked short selling should be banned.Everyone should be subjct to the same rules.Look at the recent action of the Ag stocks and their daily roller coast ride.Stict enforcement of the shorting rules will bring the retail investor back.

[Scoe]

BSCLossMan...one part of your post is dead-on... "I'm no expert".

[bearfund]

Everyone seems to agree one one thing, at least: naked shorting has to stop. So instead of dreaming up new onerous regulations, how about the SEC start enforcing the existing ones? The credible threat of losing one's seat on the exchange ought to suffice; if it doesn't, there's always a stay at Uncle Sam's pleasure. When the REG SHO list is empty for 6 months running, we can open a debate about shorts being manipulators. Until then, the only thing we all agree on is that naked shorting has to stop.

And if and when it's time to have that debate, I'll want to see records of all the PPT's meetings and actions as well. There's plenty of manipulation on the long side too, and some of us suspect the government is behind part of it. I'd love to be proved wrong on that score.

[Csense]

Short Selling should be eliminated completely. There is no rational way to justify the transaction other than Billionaires and Hedge Funds need a way to make more money. If we had a President and Congress that cared about the "people", short selling would be illegal.