How Does Short Selling Impact the Market?

Is Short Selling Good or Bad for the Market?

What is short selling?

Short selling is an investment strategy used by experienced traders that speculates on the decline of a stock or other security’s price.  A short seller opens a position by borrowing shares of a stock – usually from a broker-dealer – the investor believes will decrease in value.  The investor sells the borrowed shares to buyers willing to pay the market price. The investor is betting that the price of the stock will decline before they must return the borrowed shares so the investor can purchase them at a lower cost.  If the investor is able to buy the shares for less than they borrowed them, the investor makes a profit.  However, if the investor has to buy the shares at a higher price than what they borrowed them for, they can lose significantly. 

The good and the bad

Short sellers get a bad rap from the companies they target and the investors in those companies.  Short sellers’ tactics are arguably predatory, as they have incredible power to move the price of a stock they have a position in, especially if they sell following the release of a critical report.  Sometimes, the short sellers themselves create these reports, which critics argue are based on misleading information and fail to give a complete picture of the situation.  Nevertheless, once issued, these reports cause investors to sell their shares and the stock price to fall, which benefits short sellers.

However, activist short sellers play an important role in the market.  According to Frank Partnoy, a professor in the School of Law at the University of California, Berkeley, and Peter Molk, a professor at the University of Florida Levin College of Law, “[a]ctivists provide substantial benefits to society.”  Even Warren Buffet has a positive take on short selling: “Short sellers – the situation in which there have been huge short interests very often – very often have been later revealed to be frauds or semi-frauds.” 

Short selling strengthens the market by exposing which companies’ stock prices are inflated.  In looking for overvalued companies in which to invest, short sellers can uncover accounting inconsistencies and other questionable practices before the market at large does.  For example, short sellers have identified and exposed fraud in Enron, Sino-Forest, Wirecard AG, and Luckin Coffee.  Further, once a security’s price adjusts to its true value, investors unwilling to pay the inflated price can then purchase the security at its true, lower price. 

Using old rules in a new way

Late last year, the Department of Justice (DOJ) launched an investigation into investment and research firms that engage in short selling to determine if they employ manipulative trading tactics.  Specifically, the DOJ is looking into whether short sellers conspired to drive down stock prices by sharing research reports ahead of time.

In imposing a conspiracy theory, the DOJ is exploring whether it can use the Racketeer Influenced and Corrupt Organizations Act, or RICO, originally intended to prosecute the mafia, to hold short sellers accountable.  The investigation is focused on whether short sellers’ engaged in “spoofing” and “scalping.”  Banned in 2010, spoofing is an illegal practice in which a trader floods the market with fake orders to influence a stock price.  Scalping happens when activist short sellers sell out of their position for profits without disclosing it.  Both practices that can lead to big gains for traders. To date, the DOJ has seized hardware, trading records, and private messages from short sellers.

The DOJ is also investigating the relationships among hedge funds and short-selling firms that publish negative reports on publicly traded companies on the theory that coordinated trading is designed to create boost trading volumes and drive prices down on news of the short report.  However, the DOJ has yet to accuse any of the nearly 30 investment and research firms it is investigating of wrongdoing.

The SEC’s involvement

Concurrently, the U.S. Securities and Exchange Commission (SEC) is contemplating new rules for short sellers, including a requirement that short sellers who hold a short position of at least $10 million or the equivalent of 2.5% or more of the total shares outstanding submit monthly reports about the positions.  This move is in part in response to the events of January 2021, when retail investors engaged in a “short squeeze” of hedge funds that were shorting shares of GameStop and AMC Entertainment.  According to SEC chairman, Gary Gensler, the new requirement will “provide the public and market participants with more visibility into the behavior of large short sellers” and “help us to better oversee the markets and understand the role short selling may play in market events.” 

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