The Short Sell Ban: Are Markets Now Less Efficient and More Risky?

The federal-induced short-squeeze is now going global, as countries from Australia, Taiwan, and the Netherlands join the U.S. and U.K. in prohibiting some short selling (see WSJ article).

Potential problems with the short-sell ban are already becoming evident as those needing to hedge positions, or those making a market in derivative products, are finding it difficult to comply. During the last order the SEC had already considered some restrictions on market makers who need to short stock when making a market in put options. Now, the SEC is also considering allowing short-selling to be used in some cases as a hedge - it is expected that they will allow such shorting.

Of course, where do you draw the line? What about hedge funds that actually hedge their positions? Will they be excluded?

What about convertible bond and arbitrage positions? What about allowing investors to hedge their investments when companies raise money in a rights offerings?

What if the sale is for risk management purposes? If risk management is considered a viable reason for shorting, couldn't everything be considered risk management to some degree? Isn't shorting an overvalued company a way to take the risk of the overvalued stock out of the marketplace?

Yes, this argument is a little much, but the point is that once again it is difficult to know where to draw the line when making exceptions, which only becomes more difficult as the unintended consequences start becoming worse than what the order was hoping to accomplish in the first place.

While the order did seem to stem the selling tide last week, it ultimately makes the stock market more inefficient. If now less efficient, does this mean that the market is in fact now more risky, given that prices are more artificial than before, and that any snap-backs could be worse in the long-run (if the order is removed)?

These are questions that will no doubt only be clear with 20-20 hindsight. Extraordinary times do often require extraordinary measures, but eventually we are going to come to regret interfering with a market structure and mechanism that was put in place to keep us all honest, and keep prices as efficient as possible.

Finally, I do find it ironic that for the last year or so we have continued to complain about how the prices of all the various credit default swaps and CDOs were difficult to price, making it even more difficult to know their current value and a company's true level of exposure for holding such securities. One can argue that we are now starting to make transparency mistakes with our equities.

Disclosure: None

Comments

[GKM:]

Yes.

2008 Sep 22 01:49 PM

[who:]

spot on

short selling is symptom not the cause

2008 Sep 22 01:57 PM

[SW Richmond:]

"Are Markets Now Less Efficient and More Risky?"

Of course. Note that I would make this argument even if the fact of hedging risk was not evident. The fact that lopsided, upward-biased market controls need to be imposed is the singular historic indication that it is time to run from a market. Run as far and as fast as you can. I can't believe more people don't see this. The market is running on printed and injected money and regulatory bias and NOT on the underlying business fundamentals of the companies. When has this ever ended well?

2008 Sep 22 02:45 PM

[mdmrjsds:]

Surely there are ways to have markets without allowing price manipulation. And make no mistake, shorting is price manipulation.

It may be that markets are less efficient and more risky in some sense, but I would argue they are far more stable. Does the stability add more value than any hypothetical loss of efficiency or increase in risk? I'd want to see numbers, but the last few months indicate the cost of the loss of stability. It is as if we want to wring the last few mph out of a jet and take it farther and farther beyond design until it self destructs. Better to fly within design parameters and almost always get to the destination. Which airline would you fly? One which got you there in 5 hours 5 minutes and had a 10% chance of crashing? Or one which got you there in 5 hours 10 minutes and had a .0001% chance of crashing?

What changes without shorting is not that stocks can no longer go down. They can and will go down if the fundamentals reflect it. Look at Shanghai. No, what is missing is the ability to *drive* stock prices lower. Yes, market manipulators, momentum investors, day traders, fraud artists miss that, but do investors? By investors I mean purchasers who think of a company as a wealth generation machine they are buying a piece of? I don't think so.

And if some investments would be foregone without shorting, perhaps those were investments that shouldn't be made anyway. They don't make economic sense with your risk aversion profile.

Shorting is like betting in a dice game and being able to shave the dice. If you want to bet on stock prices, buy options. Zero sum game with no effect on the underlying except via sentiment if there is no shorting involved.

2008 Sep 22 04:24 PM

[williambanzai7:]

How The Grinch Almost Killed Wall Street
(How the Grinch Stole Christmas revised by
William Banzai7)

Every Banker down on Wall Street Liked CDOS a lot...
But the Grinch,Who lived just north in Greenwich, Did NOT!
The Grinch hated those Street jerks for a whole list of reasons!
Now, that is why we are having this exciting fall season.
It could be his trader head was screwed on just right.
It could be, perhaps, that his white shoes were a little too tight.
But I think that the most likely reason of all,
May have been that his NAV was 12 sizes too small.
Whatever the reason, His smarts or his shoes,
He stood there last week, hating all Wall Street's Whose Whos,
Staring down at his trading NAV with a sour, Grinchy frown,
Detesting those warm lighted screens in Wall Street town.
For he knew every Captain down in Wall Street beneath,
Was busy now, trying to sail through the great Subprime reef.
"And they're firing their traders" he snarled with a sneer,
"In three months its Christmas! It's practically here!"
Then he growled, with his Grinch fingers nervously drumming,
"I MUST find some way to give those investment bankers a drubbing!"
For Tomorrow, he knew, all the Whose Who of Bankers,
Would wake bright and early. And rush to save all their bonus earnings!
And then! Oh, the noise! Oh, the Noise!
Noise! Noise! Noise!
That's one thing he hated! The NOISE!
NOISE! NOISE! NOISE!
Then the Whose Whos, young and old, would all fly Far East.
And they'd try to talk Korea and China into feasting on trading book yeast!
And they'd feast! And they'd FEAST!
FEAST! FEAST! FEAST!
They would feast on champagne and rare banker roast beast.
Which was something the Grinch couldn't stand in the least!
And THEN They'd do something He liked least of all!
Every Who down in Wall Street, the Bulls and the Bears,
Would stand close together, with opening bells ringing.
They'd stand hand-in-hand. And the Whos would start singing!
They'd sing! And they'd sing! And they'd SING!
SING! SING! SING!
And the more the Grinch thought of this Singing,
The more the Grinch thought, "I must stop this whole thing!"
"Why, for year after year I've put up with it now!"
"I MUST stop a Wall Street bailout from coming! But HOW?"
Then he got an idea! An awful idea!
THE GRINCH GOT A WONDERFUL, AWFUL IDEA!
"I know just what to do!" The Grinch laughed in his throat.
And he made a some quick calls to spread rumours of unkown CDS stew.
And he chuckled, and clucked, "What a great short seller trick!"
"With this phone and this screen, I'll batter those Wall Street Dicks!"

"PoohPooh to the Whose Whos!" he was grinchishly humming.
"They're finding out now that no White Knight is coming!"
"They're just waking up! I know just what they'll do!"
"Their mouths will hang open a minute or two,
Then the Whos down in Wall Street will all cry BooHoo!"
"That's a noise," grinned the Grinch, "That I simply MUST hear!"
So he paused. And the Grinch put his hand to his ear.
And he did hear noises over the trading screen glow.
It started low. Then it started to grow.
But the sound wasn't sad! Why, this sound sounded merry!
It couldn't be so! But it WAS merry! VERY!
He stared down at Bloomberg and Reuters! The Grinch popped his eyes!
Then he shook! What he saw was a shocking surprise!
Every banker down in Wall Street, the longs and the shorts,
Was singing! Without any White Knight at all!
He HADN'T seen a Big Wall Street bailout coming! IT CAME!
Somehow or other, it came!
And the Grinch, stood puzzling and puzzling: "How could it be so?"
"It came with out tickers! It came without a tab!"
"It came as Federal largesse in boxes and bags!"
And he puzzled three hours, till his puzzler was sore.
Then the Grinch thought of something he hadn't before!
"Maybe a Bailout," he thought, "is not just for financial Whooers"
"Maybe Fed bailout...perhaps...me... a little bit more!"
And what happened then? Well...on Greenwich Main Street they say,
That the Grinch's taxes grew 12 sizes that day!
And the minute his wallet didn't feel quite so tight,
He whizzed with his Lexus through the Bronx morning light,
And he met those Wall Street boys for a Smith & Wolensky feast!
And he, HE HIMSELF! The Grinch carved the beef!

2008 Sep 22 11:48 PM

[Daniel Moser:]

That was completely awesome!!!

2008 Sep 23 10:18 AM

[Crookedwood:]

Short selling adds to market efficiency and the elimination of the practice increases the inefficiency of the market. Improve the regulation of short selling and the market benefits. The risk in the market has been compounded. How do you measure value moment by moment in the market without the presence of the opposition?

2008 Sep 23 12:11 PM

[turkeyeyes:]

Shorts to be extinct soon. Amen.

2008 Sep 27 07:37 AM