Don't shoot the messenger

Feb 27th 2003
From The Economist print edition

Although it is under fire, short-selling should be encouraged

WHEN markets fall, short-sellers—who try to make money by selling shares they do not own, in the hope of buying them back at a lower price—become everybody's favourite whipping-boys. They are accused of aggravating pain by further driving down the market. Before long, people start muttering that something must be done to stop the tawdry practice.

Those who call for restrictions are often trying to run companies in trouble, or entire economies that are on the ropes. David Prosser, chief executive of Legal & General, a British insurer, called last summer for more “grit in the system” to work against short-selling. A little later, L&G tapped shareholders in a rights issue for £800m ($1.2 billion). Last year, Hans Eichel, Germany's finance minister, proposed banning short-selling in times of crisis. In 2002 the German stockmarket fell by 44%.

Admittedly, unflattering or even downright misleading rumours are sometimes spread about a company's financial state, in internet chat-rooms, research notes and through leaks to the media. By shorting the shares, so-called stockbusters hope to benefit. That said, during the boom years, similar tactics were used by those who were hyping shares, mainly tech stocks, for personal gain. Did they do any less damage?

In fact, short-sellers usually deserve more praise than blame. Sometimes they are among the first to spot trouble. For years Tyco vilified David Tice of Prudent Bear, a fund manager specialising in short-selling, for his negative stance on the company. Not long before Tyco went bankrupt it was still buying full-page advertisements to campaign against short-selling. Jim Chanos at Kynikos, another short fund, was one of the first to notice Enron's unorthodox accounting practices.

Nor are these the only examples. Owen Lamont of the University of Chicago studied 270 companies that fought short-sellers by demonising them publicly, hiring private investigators to spy on them, or taking them to court. The companies' shares fell on average by more than 40%, relative to the market, over the next three years.

Listen to the likes of Mr Eichel, and you might suppose that short-sellers drive down entire stockmarkets. In fact, they tend to focus on individual companies. Lately, it has been big institutional investors, such as insurance companies or pension funds, that have dragged down stockmarkets and amplified the effects of already falling prices. British insurers, which own about one-fifth of the shares listed on the London Stock Exchange, have sold billions-worth of equities to reduce their exposure to the stockmarket and to meet regulatory requirements on solvency. Short-sellers are minuscule in comparison, accounting for a mere 1-3% of the capitalisation of the FTSE 100.

Short-selling is similarly small in America. Short interest outstanding at the New York Stock Exchange is some 1.4% of the market's value. Jens Johansen of UBS Warburg estimates that short interest outstanding worldwide is about $230 billion, a tiny fraction of market capitalisation. About 45 hedge funds in America specialise in short-selling. These have about $4 billion under management, less than 1% of total hedge-fund assets.

In bull markets (remember them?), short-sellers can help to put a brake on irrational exuberance. Constraints on short-selling allowed stocks to become more overvalued during the most recent bull run, says Jeremy Stein of Harvard University. More short-selling then might have made the bear market less painful now.

America's restrictions on short-selling were introduced after the market crash of 1929. The Securities and Exchange Commission (SEC) pioneered the “uptick” rule, which says that a share can be sold short only if its previous price move was upwards. The SEC denies that it has any plans further to tighten the rules on short-selling—although it is looking into stricter regulation of hedge funds, which do much of it. Eliot Spitzer, New York state's attorney-general, is looking at short-selling as part of his battle against Wall Street.

Japan's government toughened its rules on short sales as part of an anti-deflation package announced in February last year. This was a thinly veiled attempt to boost the stockmarket before March 31st, the end of most companies' financial year. The restrictions, requiring an uptick before shares can be shorted, brought Japan's rules into line with America's.

Despite Mr Eichel's frowns, short-selling is not proscribed in Germany. Mr Eichel did indeed include a temporary ban on short-selling in a draft financial-markets law last year, but the parliament's upper house rejected it. Short-selling is anyway rare in Germany: most banks will not lend shares to short-sellers.

Although Britain's Financial Services Authority (FSA) is sanguine about short-selling, it may require fund managers to disclose their aggregate short positions. “If you short more than 3% of the outstanding issue, you should disclose,” says Hugh Hendry of Odey Asset Management. This would help to uncover hedge-fund managers who collude to push down smaller stocks with poor liquidity.

Maybe other regulators should be as cool as the FSA. Beleaguered American companies are lobbying Mr Spitzer and the SEC to crack down on short-selling. Yet if anything, they should be doing the opposite. “Even scrapping the uptick rule would not unleash a torrent of short-selling,” says Mr Stein at Harvard. Mutual funds and most institutional investors consider shorting too risky, since losses are theoretically limitless when a shorted stock starts to rise. Investors should be grateful that somebody is willing to take such risks.