Friday, September 19, 2008

Arguments for and against the ban on ALL short selling

Is the outright ban on short selling a good move by the government? Does it make sense? Or is it a costly brake on a crucial market check and balance from launching the next “irrational exuberance”? There are good arguments for both sides, and many of these arguments can be found in both the main article, and in the comments section, of this post from the UK Telegraph.

Among the arguments against the ban:

From the author: "Liquidity will now dry up in these stocks so that any buying or selling of the affected companies will have massive ramifications on the prices of the companies concerned as dealers and Market Makers just pass the risk on immediately down the line, generating swathes of price action on limited business.

With limited ability to borrow stock, Market Makers will widen prices to reflect the increased risk and costs of transaction. With bank share prices now propped up artificially, it makes it even more difficult to decide on where to place funds as the information provided by share price movements is no longer available."

From the commenters: "Most short selling is done as part of a combined package of trades. The short selling part of which is usually a form of hedging i.e. to reduce risk in a financial position. e.g. convertible bond volatility trading requires the "equity option" element of the bond to be hedged. This is done by selling short enough shares to offset the implied long position in the option. Once hedged the trading position makes money when the price of the shares goes "up" OR "down". This trading strategy is indifferent to share price movements in either direction, only that they do move up or down (hence the name - volatility trading). The embargo on short selling is not only foolhardy, but will not give those seeking a convenient scapegoat a target for long. Sentiment is driving the lack of liquidity in the capital markets(not economic fundamentals or short selling)"

Arguments from those for the ban, all coming from the commenters:

“I’m a fervent believer in the increased market efficiencies of short selling. But, unlike “longs”, “shorts” can create a self-fulfilling prophecy of value destruction when a company needs capital - or when the shorts instil fear in an already fearful marketplace.

Thus, while short selling may well serve a wonderful purpose in nearly all market conditions, the market today is not “orderly”. Instead, it is getting dangerously close to a panic. In this environment, shorting is creating a market inefficiency (immediate business closures / sales based on incomplete information), whereas in normal times it creates a market efficiency. I am not an advocate the ban of all new short positions in the financials indefinitely. Had the regulators failed to do this, I believe that we really could have created a downwards spiral that could unwind both our financial system and our economy in a dangerous way.”

“There is always going to be moral dilemma in a society that has to be guided by 'common humanity' and promotes human rights that allows individual freedom and emancipation. But, we are part of a large society which must be sustained and given vitality. So like in times of great disaster where society is in danger, governments must intervene and regulate.”

“Free Markets are all very well, but when you see them stampeding about like great big herds of cattle that have been spooked, it's time to ask whether they should not be reigned in a little through regulation."

“Now free trading of stocks is an essential element of our society that should be safeguarded. However, borrowing gigantic amounts of stock and then leveraging this borrowed stock to create self-fulfilling market conditions (greatly exacerbated by automatic trading software that will dump stock that crashes through their pre-set minimum) seems to be good for little else than creating instability. In fact, it is most difficult to see how it contributes to equilibrium stock pricing, which is the first function of the stock market. Short-selling may "alert people to the weakness of a stock", but ordinary trading will do that just as well, and more gradually.”

My own opinion is that, though I generally agree with the principle that short selling is a good market corrector, banning it at this time is a crucial component of the government’s solution to the crisis.

Given that the painful solution involves bailing out institutions that are deemed too big and inter-connected to fail, allowing short selling to continue would have only made the bailout more expensive for the taxpayer. Short selling was making it even harder for the financial institutions to raise needed capital. It would have been another form of privatizing gains (for the short sellers) while socializing losses (to the taxpayers). Looking at the larger picture, it is not about rewarding the reckless behavior of the banks.

So I agree that banning short selling made sense, and I also agree that it should be only until this crisis has been resolved. I trust that the government, with the guidance of the market, should know when that ban has had its run.

Similar-themed post here.

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