1) The author argues that short sellers provide important benefits to financial markets by improving pricing and adding liquidity, yet they are often unfairly blamed for market declines. 2) Regulators have in the past banned short selling in attempts to support stock prices, but this only led to short squeezes and market instability without achieving the intended goal. 3) Short sellers assume more risk than long investors and should be able to operate in fair and transparent markets, not face manipulation, in order to fulfill their important role in equity markets.

1. the gulf | December 13-19, 2008
opinion
33
by Robert Aspin
W
hatever one thinks
of the way that
Porsche was able
in October to gain effective
control over 74 per cent of
Volkswagen’s stock – causing a
short squeeze of 400 per cent
in the process – short sellers
have come under undue pres-
sure of late. Shorting, or selling
short, is when an investor
agrees to sell securities that he
or she does not already own.
The investor is betting that
the price of the securities will
fall by the time they must be
delivered. If they do, the seller
makes a profit on the deal. If
they do not, the seller must
buy them at a premium and so
could lose money.
In most cases, short selling is
used by investors as a way to
hedge positions that are held
long – that is, in the belief
that they will rise in value. For
example, an investor holding
Toyota shares may wish to
hedge some of the market or
sector risk by shorting a similar
value of shares in General
Motors, a company whose
fundamentals are less sound.
Too often, however, short
sellers are blamed for causing
stock markets to fall as was the
case recently. Because of such
perceptions, regulators in the
US not so long ago banned any
new short selling in the shares
of some 900 firms in an effort
to support the equity markets.
The UK and European regula-
tors did likewise on a number
of financial stocks. All this did
was contribute to a huge short
squeeze – when a shortage of
supply and excessive demand
push up the price of a stock –
and did nothing for the longer
term stability of the markets
which continued to fall several
days later. The regulators later
dropped the ban because they
realised it was ineffective.
In banning mechanisms such
as shorting, the regulators end
up either manipulating the
markets themselves or facilitat-
ing the attempts of others to
do so. As a result, they fail in
their duty to provide a level
playing field for participants
in the equity markets. Such
failures not only affect short
sellers directly but lead to
distrust in the system. For
example, investors who were
legitimately shorting Citibank
or HBOS shares may have been
forced, on the back of the resul-
tant short squeeze, to cover
their positions or to sell other
stocks in order to meet calls for
margin from brokers or others
from whom they had borrowed
money. As this can cause inves-
tors to sell holdings in other
stocks, the impact cascades
through the markets and leads
to dislocations in prices.
In many cases such misguided
tactics on the part of regula-
tors lead to losses which have
resulted in the closure of some
hedge funds. This benefits few
market participants and again
creates price dislocations as
positions are closed.
Short sellers also provide
improved market pricing since
expensive stocks can be sold
down in price, while cheap
stocks are bid up. A further
benefit of shorting – and a criti-
cal one too – is that it provides
liquidity if a market reaches
a point of panic and becomes
over-sold. Short sellers are the
first buyers in any market as
they seek to cover their posi-
tions and to reduce any hedges
that they may hold. Hedge
funds, short sellers and merger
arbitrage managers all add to
the liquidity of the markets
which contributes to their abil-
ity to operate effectively.
While shorting is a means of
reducing portfolio risk – hedg-
ing a position in a stock, using
shorts, helps to reduce a fund’s
volatility and the impact of a
fall in the market – short sellers
assume significantly more risk
than most investors since the
loss on a short can far exceed
the loss on a long trade. By
definition, this is limited to 100
per cent of the value of the
investment. It is thus critical
that they can operate in a fair,
liquid and transparent market.
Rather than castigating them,
regulators and market partici-
pants should applaud short
sellers for what they bring to
financial markets.
They accept the risks of their
profession but should not
have to endure manipulation
by those who would prevent
it. This jeopardises the very
foundation of an equity market,
which is what regulators are
trying to defend. China’s recent
decision to allow shorting on its
markets should be a wake-up
call to regulators elsewhere.
The story of Volkswagen
had a happy end to it, at
least for Porsche. The firm
later announced that it would
provide some liquidity to the
market by exercising part of
the cash option on the VW
shares it had acquired. Given
that Porsche profited signifi-
cantly from the decision, the
company’s own stock rose by
more than 30 per cent on the
announcement. Speculation
continues as to whether the
company will exercise the
remaining options for cash or
acquire the underlying stock.
Was it manipulation on an
unprecedented scale? I know
what I think. <
Robert Aspin has more than
14 years of international
experience in the financial
sector. He has submitted an
application to the Central Bank
of Bahrain to establish an asset
management firm
Illustration:TimGravestock
financial markets
In praise of shorting