Selling securities short has been a controversial practice as long as financial markets have existed, and the recent ban on short selling by the European Securities and Markets Authority
(ESMA) has brought short selling to the fore yet again. Yesterday, amid heightened global volatility, ESMA announced that Belgium, France, Italy and Spain are banning short selling on financial stocks for 15 days. ESMA, European Union?s version of the Securities and Exchange Board of India, additionally reminded market participants that it is prohibited to disseminate false or misleading information, as they have sparked sharp sell-offs recently. Short selling was banned across these four specific markets after ESMA failed to agree on a coordinated ban.
Short selling positions make money if stock prices indeed go down as speculated, and are typically done in conjunction with bear raids. A bear raid is a set of trades in which a stock is sold short at a high price, negative rumours are spread to cause the price to fall, and then the short sales are covered by purchasing the stock at the lower price. Buying stock on the way back up, if the stock price bounces back, is a way of adding to the raider?s profits from manipulating the stock price. While it may be beneficial for the speculator, for a financial institution, a decline in its stock price may at times cause irreparable damage, because their funding source is based on confidence.
One of the most glaring examples of the dangers of short selling happened in March 2008. On March 11, somebody?nobody knows who?made one of the wildest bets Wall Street has ever seen. The mystery figure spent $1.7 million on a series of put options, gambling that the stock price of Bear Stearns would lose more than half their value in nine days or less. It was like buying 1.7 million of lottery tickets. But what was astounding was that the bet paid off.
At the close of business that afternoon, Bear Stearns was trading at $62.97. At that point, whoever made the gamble owned the right to sell huge bundles of Bear stock, at $30 and $25, on or before March 20. In order for the bet to pay, Bear would have to fall harder and faster than any investment bank in history. And it did.
The very next day, Bear Stearns went into free fall. By the end of the week, the firm had lost virtually all of its cash and was clinging to promises of aid by the Fed. By the weekend, it was forced to sell itself to JPMorgan. JPMorgan was given $29 billion in public money as a dowry to marry the hunchbacked bride, Bear Stearns, at the humiliating price of $2 a share. Whoever bought those options on March 11 woke up on the morning of March 17 having made more than 150 times his money, or roughly $270 million. The problem is not that the investor concerned profited from Bear Stearns? declining fortunes, but that he acted as a catalyst for the bank?s demise.
Likewise, David Einhorn, a long-short value-oriented hedge fund manager started betting on Lehman Brothers? collapse. In April 2008, a month after the Bear Stearns debacle, Einhorn started spreading rumours about short positions on Lehman stock. Lehman CFO had a private call with Einhorn which the latter made public to trigger a decline in Lehman?s share price. This resulted in greater media coverage of Lehman?s difficult funding position, precipitating the crisis of confidence. When Bear and Lehman made their final leap off the cliff of history, both undeniably got a push from short sellers. The Securities and Exchange Commission (SEC) banned short-selling after the collapse of Lehman but it was too late by then. We are all aware of the tailspin into which financial markets went after the Lehman bankruptcy. To give SEC its due credit, the panic may have been possibly worse without the ban. Who knows, if only SEC had banned short-selling earlier, like ESMA has done now, speculators like Einhorn may not have been able to make a windfall and facilitate the bank?s collapse.
There would be a large section of the market participants who would cry hoarse and would present the usual arguments that banning short selling disrupts the price discovery process and affects liquidity. The market participants are not so concerned about price discovery as much as rueing the lost opportunity to make a quick buck on the collapse of a financial institution. For the regulator, sometimes rescuing institutions from these speculators should rightly be a higher priority than worrying about price discovery and liquidity in the short term. And that?s what ESMA has done. It is a conservative move, but it is better than allowing speculators to possibly precipitate a crisis.
The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance