Should we have short sale bans?

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Some countries are banning or limiting short selling but ASIC has told Josh Frydenberg this isn’t necessary. Wayne Swan banned short selling during the GFC. Was this right then and should we be considering it now?

Although it is understandable that some governments are looking to calm financial markets, banning short selling is NOT the right strategy.

Banning short selling did not work during the GFC, and it will not work today. Many academic studies have rigorously shown that short-selling bans do not lead to share price support. Short-selling bans have only led to greater illiquidity, increases in volatility, and higher probabilities of default (Beber and Pagano, (2013); Boehmer, Jones, and Zhang (2009); Marsh and Payne (2012)).

Short selling exists because it allows investors to take positions against companies that have bad managers. Short selling does not destroy companies, bad managers do. If you believe a business has strong growth opportunities, you buy it. If you think the business is overvalued and has a poor outlook due to poor management or suboptimal political or economic conditions, you short-sell. That is how capital markets work. Financial managers of listed companies who do not like this should not even list their companies if they are unable to accept the volatile nature of financial markets. Investors who do not like the volatile nature of equity markets can invest in cash or fixed income.

At present, with the COVID-19 crisis the revenues and profits of many companies will be negatively impacted by the crisis and investors are incorporating their views by short-selling. This is a rational response for fund managers who need to ensure their fund performs as they need to protect the interests of their investors too.

To understand why banning short selling doesn’t work, we need to understand how it is carried out in practice. A short seller needs to borrow the shares from another investor who has a long position in that stock. In order for the long investor to lend his shares to the short seller, he will charge a fee to the short seller. Many long investors are unwilling to lend their stock to a short seller as this will impact their long term position, thus there is usually a very limited supply of stocks available for a short seller to borrow, and for those that do agree to lending their stocks to short sellers, the fee charges to the short seller can be punitive.

The whole process of lending stocks to a short seller is called “securities lending” which is a profitable business for large asset managers such as Fidelity, BlackRock, and State Street. The process of lending stocks to short-sellers is tightly managed by fund managers and the fees accrued from doing so are often passed on to the investors of their funds.

Even if a ban on short selling shares is applied, there are a large variety of financial derivatives that can be used to profit when markets fall. Retail investors may not be able to access other financial products such as options and futures to take a short position, but sophisticated institutional investors do. It is sophisticated investors who have the financial clout to make a substantial dent in share prices, not retail investors.

Thus, banning short selling does not work. Although it might be painful for superannuation funds in the short term, short-selling ensures that capital markets are efficient in the long-run.

Given no-one can predict how the COVID-19 pandemic will pan out, is there anything that might trigger this reaction in the future?

I don’t really understand this question. Economic downturns are - or should be - a fact of life for investors. Economic downturns occur approximately every decade. For example, 1987 Black Monday, 2000 Dot-com Crisis, 2007-2009 Global Financial Crisis, and now the 2019 COVID Crisis. I’m sure in around 2029 there will be another financial crisis that will trigger another round of short-selling.

Private equity firms like BlackStone and Berkshire Hathaway have been hoarding “dry powder” (multi-billion dollar cash piles) in preparation for the next crisis so they can purchase shares cheaply and make profitable trades. It is well-known that Warren Buffet has been saying that equities are currently too expensive and many Wall St analysts have decried the fact that many corporations are highly leveraged due to cheap debt and low interest rates, and household debt is reaching all-time highs.

I would say that many professional investors expected a financial crisis; however no one knew what the trigger would be and certainly no one expected a global pandemic to be the trigger.

How does short selling usually affect listed businesses and will the impact be different in the current environment?

First, short sellers cannot drive a company to bankruptcy due to the mechanics of the short selling process. Some listed businesses that have issued corporate debt or hybrid securities as part of a capital raise can be impacted by debt covenants that may include clauses about share prices being above a certain level; however, such covenants are few and far between.

Listed businesses that are managed well will come out of this crisis stronger than ever.

What should listed businesses do if they are subject of short sellers?

Listed businesses should understand why they are the subject of short sellers. Is it due to bad management practices? A misunderstanding by investors of certain management decisions made within the company? Geo-political concerns that are beyond the control of company management?

• Listed companies should boost their investment relations and public relations by informing the market of why certain decisions are being made, and why it is best for the well-being of all shareholders.

• If there are geo-political events that are beyond the control of managers, they should be taking steps to mitigate these risks and informing investor relations of what these steps are.

• Managers that believe that their share prices are low relative to company fundamentals can choose to perform share buybacks to as a signaling effect to inform investors that they believe that the best use of company funds is to invest in itself.

The practice of short selling is a very risky, short-lived investment strategy. In the long term, if company managers make the right decisions and share prices maintain an upward trend, short sellers can lose an infinite amount of capital, including the fees they are paying to the lenders. The best advice to company management is to ignore short sellers and focus on doing their jobs well.