Should naked short selling be illegal?

Should naked short selling be illegal? by Laurent Bernut

Answer by Laurent Bernut:

Let’s leave the adorable legal answers from “investors” aside for one minute and let’s think about what would happen if naked short selling was legal

A. Price discovery and price equilibrium

Many issues are un-shortable because there is no borrow available. It is a bit like artic ice. They slowly melt away until they liquify real precipitously.

The ability to short w/o having to source borrow first, would hasten price discovery. At some point, buyers would meet sellers, and there would be price equilibrium.

Short sellers facilitate price discovery

B. Transaction cost, volatility and market impact

In 2012, There was a landmark study on the impact of short selling done by the New York Fed. Long Buyers could only buy from a Long sellers. Bid/ask spread widened. The ban on short selling financial services materially increased transaction cost, volatility and reduced liquidity. Short selling has a net positive impact on transaction cost

Short sellers provide liquidity

C. Hedging

Not all short sellers want the underlying companies to bite the dust. In fact, only the emotional short sellers with a distorted sense of fairness do.

People sell short for all kinds of reasons. If You cannot sell short, you cannot hedge, Therefore, you cannot underwrite products such as options, futures, CBs. Now, there is a natural limitation coming from the borrow available. Put/cll parity goes out of whack for hard to borrow issues

Short selling provides better pricing on derivatives

D. What would happen if You sell sth You do not own?

Regardless of whether You sold naked or covered, you are still liable for the difference between the selling and the buying price. There is no way your broker will forgive your losses. So, what’s the problem here? the ability to drive prices into the ground, fairness, moral high ground,

In theory, if You do not need to own a stock, then You could short ad infinitum and potentially drive prices into the ground. Reality check: this happens … on the Long side. People do buy something they do not own yet. Does it drive prices to the moon? No, there is equilibrium between buyers and sellers

Now, naked short selling for the purpose of hedging other instruments such as derivatives is a different issue. Put underwriters delta hedge

As for fairness, put yourself in the shoes of a short seller for one second. More often than not, You are denied the ability to short an issue simply because there is no borrow. Borrow comes from LT large shareholders and institutions lending their shares. So, you are at the mercy of people who may decide not to lend or even recall their stock at anytime. Meanwhile, buyers are not at the mercy of anyone if they want to buy a stock. So, who is treated unfairly now?

The only two ways to live your life: Hero or victim

People who complain about short sellers are usually disgruntled righteous “stock pickers”. They get into some stock, which immediately proceeds to go Valeant on them. Then, they blame short sellers from driving prices down. One thing they need to know, borrow available is less than 10% of daily volume on average. So, yes someone is selling big time, but not the short sellers. Think about this next time You see a stock tanking: for every smart investor who has bought the stock, there is a smarter investor liquidating now. Just ask yourself Why

More importantly, there are two ways to live your life. Either You are the hero and triumph over adversity. Either You are the victim of circumstances, evil speculators, the system, the government. when people blame short sellers, they obviously take the role of the victim.

Now, if You were a pension asset allocator with money to deploy, who would You trust?

1. someone who acts as a heroin and assumes responsibility for her mistakes or,
2. someone who plays victim and blame everyone else for his lousy stock performance

Think about it next time You blame short sellers. Unlike underperforming “investors”, Short sellers do provide vallue

Should naked short selling be illegal?