Does Short Selling Sell Us Short?

Commentary, Economy, Lee Harding

Paraphrasing a remark by American philosopher Nicholas Murray Butler in 1931, John Newbern once said: “People can be divided into three groups: those who make things happen, those who watch things happen and those who wonder what happened.” Each of those classes is well-populated when it comes to GameStop, a company whose stock rose dramatically in January, handsomely rewarding investors and punishing what are called short-sellers. If you count yourselves among those who wonder what happened, get ready for enlightenment.

Short-selling, or shorting, starts this way. An investor borrows shares, usually from a broker-dealer, with an agreement that the owner will receive them back at a set time. The investor borrows the shares at interest and sells them right away. They don’t actually own those shares, which means they are “short” of them. The investor’s entire profit margin is based on a bet that the stock will drop in value and they can buy it back at a lower price than it was loaned to them and restore the borrowed shares at a profit.

Short-selling is, to borrow a movie title, risky business.

Here’s where GameStop comes in. The retail chain with over 5,000 locations across North America sells video games and related accessories. When it was rumoured that hedge funds were trying to short the stock, some members of the Reddit community WallStreetBets told readers to buy the stocks and refuse to sell. The stock skyrocketed in value, panicking short-sellers who could only buy the stock back at a substantial lossif at all. Before January ended, research firm S3 calculated that short-sellers lost $5 billion on GameStop stock that month alone.

The plot thickened as Robinhood, E-Trade, Interactive Brokers and Apex Holdings refused to book orders for GameStop stocks. Every-day investors cried foul, claiming Wall Street influence re-rigged the system the moment that every-day people beat them at their own game. The Robinhood app received 100,000 one-star reviews (soon deleted by Google) and the company saved face by allowing limited buys of the stock to continue.

Stocks in BlackBerry, AMC, Bed, Bath and Beyond and Tootsie Roll also rose dramatically in value for somewhat parallel reasons. In all, Wall Street titans lost $70 billion for short-selling in the first month of 2021 alone. While few shed tears for them, the phenomenon still has a downside. Tremendous investment has poured into companies whose intrinsic value does not deserve it, a distortion that kept capital from companies otherwise more worthy.

Naked short-selling is an even greater problem. Here, investors sell shorted stock they never “legitimately” borrowed, let alone owned. The practice is hard to track and was made illegal after the 2008-09 financial crisis. Just the same, the large number of FTDs (fail to deliver) at stock exchanges suggests the problem still occurs. Even when complaints are made to regulators, only a small fraction are investigated. Investors who win, win big. Big losers can file for bankruptcy, raise capital and return to the game in a new corporate entity.

Naked shorts can ruin a company. Selling stocks that don’t exist creates the same problem as counterfeit money. Artificially high supply means low demand, making the stock’s value fall. As Patrick Byrne, the founder of Overstock, explains, this can put companies into a “death spiral.” Investors see the negative momentum in the stock price and jump out. Capital markets and consumers shun the business over fears it will go under. If bankruptcy occurs, so does the short-seller’s need to come up with shorted stockswhether they were real or not. In this way, shorting becomes less of a bet and more of a self-fulfilling prophecy.

While shorting makes a few winners, it creates many more losers. Software, pharmaceuticals and high-tech companies are often the targets of short-selling. And when these companies are wiped out, so are the products and technologies they could have created, not to mention many jobs. Pension funds that held the stock also take the hit.

Lawyer Wes Christian says short-selling has destroyed $100 trillion of wealth. Although he has won 50 lawsuits against short-sellers, the required documents to win each case took years to obtain. He says those who should police the problem actually benefit as perpetrators, given their own corporate involvements. In this environment, shorting stocks has more potential for quick gains than traditional investments. This has meant some ventures have intentionally stayed private to prevent destruction by predatory and even illegal shorting.

Massive short-selling creates unhelpful distortions. A stock market is supposed to provide a platform for people and corporations to invest in enterprises to their own benefit and that of consumers. Short-selling is antithetical to these goals and should be extremely limited, if not banned. Christian and others do have proposals for reform. Unfortunately, courage and integrity are hard to find when it comes to dealing with the rich and powerful.

Lee Harding is a research associate with the Frontier Centre for Public Policy.

Photo by Clay Banks on Unsplash.