Guest Blog by Eric Jensen,
CEO & Founder, Antrim Investment Research
[Note to readers: This is our first guest blog and I think you will find it insightful and additive to the short-selling debate. I'd like to thank Eric for sharing his thoughts with our readers. - Roy]
In 2019, the German federal financial supervisory authority, “BaFin,” issued a ban on short selling in a single stock, Wirecard AG, and enforced that ban for a two month period before lifting it and allowing the markets to return to their normal course of operation. At the time, the regulatory authority argued that the ban was necessary to “protect” the payments processor, as it investigated the behavior of hedge funds that it feared were acting, “maliciously” and “in concert with media outlets,” in order to bring the company down. The same agency filed complaint against the Financial Times for their role in reporting on the Wirecard scandal. But as we now know, the allegations levied at Wirecard were accurate, and it is the German federal financial authority, rather than the Financial Times, which is now called on to justify their actions.
Commentators have rushed forward to offer various opinions on where BaFin went wrong. Investors and regulators have wondered how the agency might have been misled, or where and why their trust had been misplaced. Pundits have proposed reforms whereby auditors and regulators might be better empowered to assess the veracity of whistleblower reports and criticisms levied against companies under their purview. But few have dared to challenge the assumptions underpinning BaFin’s preferred course of action, which betray fundamental misunderstandings about the structure and machinations of the financial markets that are commonplace, both amongst investors and regulators alike. Of particular importance to this discussion, for example, is the assumption inherent to the ongoing debate about the role of short sellers in financial markets that the mere act of short selling is somehow harmful to the companies subject to such activity, or by extension, harmful to that company’s other passive shareholders. While many profess to experience a vague sense of unease at the thought of a fund manager profiting from a reduction in a company’s share price, nobody has yet argued convincingly that the act of short selling alone is detrimental to either a company, its shareholders, or to the efficient functioning of the exchange. I aim, then, as concisely as possible, to convince the reader that, quite simply, short selling is not detrimental to companies, markets and shareholders. It’s beneficial.
Short selling does not decrease the price of a company’s shares. The myth that selling decreases the price of the shares on an exchange while buying increases prices has done quite a lot to distort the public perception of the practice of short selling, but it is easily dispelled. The simple fact of the matter, obvious though it might seem, is that for every sale there is a buyer, and for every purchase, there is a seller. Selling cannot decrease prices on its own because there must always be a buyer to consummate any sale. And neither can increasing or larger amounts of selling decrease prices, because there can never be more sales than purchases, or more purchases than sales. Prices actually move only when the market participants on either side of the trade become so eager to trade that they increase their bid (or decrease their offer) in order to jump in front of the queue and make sure that they are able to transact. Because of uptick rules that require short sellers to wait for an “up-tick” in order to sell their borrowed shares, it is literally impossible for shorts to sell borrowed shares at the bid. For a stock price to collapse shares must be offered at, and then below the bid, or the bid must disappear. For a stock price to collapse, the actual owners of its shares must feel an urgency to transact that requires them to jump to the front of the line, and the prospective buyers must sit on their hands, and play coy.
That this simple fact might seem unnecessarily technical or rather nitpicky implies that the issue of liquidity in any given company’s shares is a larger one than the width of the spread between the bid and offer, or the numerical volume of shares exchanging hands over the course of a day. Rather, it is understood that the large blocks of liquidity required by fundamental investors seeking to initiate new positions or reduce existing ones are provided by other fundamental investors looking to take the opposite side of the trade at an agreed-upon price. With this realization, one might argue that a large supply of borrowed shares for sale could theoretically put a ceiling on the price of an otherwise promising issue – absorbing all the demand from new shareholders eager to initiate positions without allowing runaway inflation in prices. But that’s what liquidity is! An issue with ample liquidity is an issue for which a reasonable investor can take a reasonable position at the prevailing market price, not one for which you must compete with other buyers at ever-escalating bids in order to snatch up a small (and dwindling) number of shares on offer.
Given that nothing mechanical about the act of selling short presents a particular risk for listed equity securities, one must assume that the principal objection to the practice comes from the practice of borrowing the shares in the first place, or the idea that the value of the short seller’s liability declines as their value declines. But borrowed assets are exchanged all the time. Such is the nature of leverage in the financial markets. Those who have borrowed cash to exchange for volatile financial assets, or even to purchase productive assets in the real world, surely profit from declines in the purchasing value of the borrowed currency. There is no comparable moral objection raised when market participants are short dollars, or commodities, or bonds. That outrage is reserved only for the borrowing and sale of equity securities.
Here, the detractors to the practice of short selling fail to appreciate the broad-based benefits presented by an active program of securities lending. As has already been established, liquidity is increased by definition, as shares that would otherwise have remained closely held have been lent to market participants inclined to transact in them. With greater liquidity, there is greater access to a given issue in the marketplace. Valuations increase as illiquidity discounts evaporate and large institutions find themselves able to take increasingly larger positions. The profits from securities lending serve to reduce expense ratios for exchange traded funds and mutual funds, decreasing the cost of market access for individual investors seeking diversified and broad-based market exposure.
Nothing fundamental is lost in the process. While access and liquidity are increased, and market exposure is democratized, the actual number of shares outstanding, from a statutory perspective, is static. The number of votes (since your vote is lent out with your shares) to be counted at annual shareholder gatherings is static. Those investors who value their right to vote their shares find themselves able to, while those investors who do not have an opinion on the issues presented to shareholders can exercise their right to lend their share to someone who does, at a profit.
Short selling, therefore, is unlike other predatory or ESG-negative products that produce negative externalities and outcomes for society and a wide range of other stakeholders in the name of maximizing short term profit. “Short selling,” is nothing more than the practice of providing liquidity to investors seeking to purchase shares of public equities, where it otherwise would not have existed. That it can be done profitably is testament only to the fact that it is the nature of the prices of volatile assets to rise and fall, at least periodically, over time. It is elitist and regressive to aspire to a world where financial assets only ever increase in value and liquidity for new investors looking to put savings to productive use is scant. Preferable, then, is a marketplace where closely held securities can be lent to market participants actively looking to transact in them, leverage is regulated but available, and costs are reduced for diversified, passive funds.
And as for Wirecard, it seems rather obvious that nobody outside of the company’s C-suite of executives did more to harm its shareholders than company management themselves.
Eric Jensen is the founder & CEO of Antrim Investment Research, which is an equity research boutique focused primarily on short idea generation, with a generalist sector focus. Antrim also does work on the long side, primarily related to special situations and extremely underfollowed small and mid-cap securities. Antrim prides itself on intellectual honesty, curiosity, and creativity in its work best exemplified through its opinions and analysis, often falling outside of consensus thinking.
The thoughts and opinions expressed in this blog post are those of its author and not necessarily those of Pierpoint Financial Consulting, its partners or principals.