I can remember that, when I first heard that there was a way to make money from shares that were falling in value, I thought that was a bit weird. So I did a little research, and found out about the concept of short-selling. Short-selling is when you borrow (rather than buy) some shares in a particular company, sell them on the open market, then buy them back later and return them to their owner. If the price of the share has fallen, then the money you made from selling the shares is more than it costs to buy them back, and you get to pocket the difference. The risk is that the share price rises, in which case you have to spend more buying the shares back than you got for selling them, and are out of pocket by that amount. In other words, these kinds of trades are the mirror image of ordinary share trades, where you make money if the share price rises, and lose out if it falls.
As a result of this mirror-image aspect, short-selling is a useful way for hedge funds to balance the risks they face. Say for example that I was expecting some good news about grocery sales to be announced on Monday morning, and I expected supermarket shares to do well as a result. In anticipation of that news, I might decide to buy lots of Tesco shares today, expecting to make a profit when the price rises on Monday. But in doing so, I’m taking a risk, because there is a chance that the news won’t be as good as I’m expecting it to be, or the market won’t react in the way I expect, or some other unexpected factor will trigger a fall in supermarket share prices. One way of reducing that risk is to hedge my bets by going short on another supermarket – perhaps one that I think is in a less healthy position, and so will rise least if prices go up, and will fall furthest if prices drop – in which case some of my losses on my main trade will be offset by gains on my balancing trade. The risk of hedging my bets like this is that, if I’m right and prices do rise across the board, my total profit will be less, because some of the gains I make on my Tesco shares will be eaten up by the losses on the short trade. The potential benefit is that, if I’m wrong and prices fall across the board, my total losses will be lower, because some of the money I lost on my Tesco trade will be offset by the gains I made on the short trade.
From a purely moral perspective, short-selling still feels a little iffy, I think. Falling share prices can have real-world effects, either in terms of companies having to make widespread ‘efficiencies’ (i.e. redundancies) in order to reassure the markets or even, potentially, causing the wholesale collapse of the company if the falling share price makes it impossible for them to raise new finance. The concept of somebody making money from this scenario – making a bet, essentially, that this is the way a company’s future is going to pan out – feels distinctly uncomfortable. That said, some of the criticisms of short-selling – that it has a drastic impact on market stability, and that it can hasten the demise of otherwise healthy companies – are a little misplaced. If a share’s value is widely expected to fall, that will become a self-fulfilling prophecy – with people selling in order to stem their losses, thus causing a glut on the market and the price to fall even further – even if short-sellers are not involved in the market. The shares will be sold either way, so it makes little difference if they’re sold by their owner, or by someone who has only borrowed them. It’s also important to keep in mind that a short-trade ends with the shares being re-purchased, and this increase in demand will eventually cause the share price to rally. Another part of the whole scenario is that, while some hedge fund managers will expect a share to fall and so will go short on it, others will reach the opposite conclusion, and so will buy shares in the expectation that the price will rise. In broad terms, those managers betting on an increasing share price ought to offset those betting on a decreasing one, and thus the market as a whole should balance out.
This whole scenario still feels a little weird – it’s hard to think of any other area of life where it would even be legal, let alone ethically acceptable, to sell something you don’t own, and have no intention of ever buying – but I can at least understand that the process can work without necessarily destroying the market. The same thing can’t be said for another practice I heard about this week, when Germany announced that it was partially banning it – naked short-selling. Despite the promising name, naked short-selling isn’t part of some delicious revenge fantasy in which the bankers who fucked the world economy, having already been forced to sell the shirts off their backs, now have to take off their underpants and sell them by the side of the road in order to raise the price of a triple espresso. Naked short-selling is like ordinary short-selling, except you don’t even have to borrow the shares first. Instead of borrowing and then selling shares you don’t own, you go to the market and sell shares that you don’t have even temporarily in your possession, agreeing to deliver them to the purchaser at some (specified, or even unspecified under some regulatory regimes) point in the future.
From the perspective of the short-seller, this is a great wheeze. For a start, there’s none of that awkwardness about having to find someone who’s prepared to lend you the shares – in a market where everyone wants to short-sell, this can be a problem, because a large group of traders are chasing a finite number of shares. Since a naked short-sale doesn’t involve any actual shares until the very end of the process – the bit where the short-seller buys the shares and delivers them to the purchaser – the temporary shortage of shares available to borrow isn’t a problem. Secondly, with a traditional short-sale you have to pay the person who lends you the shares what’s called a premium – this is essentially a deposit, and ensures that, if you default on the deal, the original owner of the shares at least gets to keep the value of the shares at the time they lent them to you. This is a bit of a downer for two reasons.
To begin with, you have to actually have enough money to be able to afford to pay the premium. Secondly, while the premium is sitting with the person you’ve borrowed the shares from they’re earning interest on it instead of you. This may not sound like a big deal, but bear in mind that the people who short-sell often deal in unimaginably large sums of money, so a few days (or even hours) of interest can add up to a lot of cash. Naked short-selling neatly sidesteps these difficulties, because instead of selling actual shares, you’re only selling a promise to deliver shares in the future. Since there are no actual shares to borrow, you don’t have to pay a premium. Even better, you can use the money the purchaser pays you now to buy the shares you’re going to give to them later, so you can engage in the trade even if you don’t yourself have enough money to buy the shares. Provided your bet is right, and the price of the shares you’ve nakedly short-sold falls, you make a profit with somebody else’s money, but get to keep it all to yourself.
As with all good wheezes, of course, there are a number of downsides. Let’s look at the biggest of them.
The virtual nature of the ‘shares’ that change hands in the first stage of a naked short-sale – the bit where a purchaser agrees to pay now for the promise of shares to be delivered at some point in the future – means that there are no limits to the numbers of such ‘shares’ that can be made instantly available for sale. (Indeed, one of the few ways it’s possible to tell if a lot of naked short-selling is going on is that, if it is, the volume of shares traded will exceed the total number of actual shares.) There are two main problems with this.
Firstly, even if there are people who think a company’s shares are a good investment – and for short-selling to be possible there must be; something can only be sold if there’s someone who wants to buy it – there are no limits to how low the price can fall. Normally, the price of a share would start to rally when it began to get scarce, but these virtual shares can be pumped indefinitely into the market, creating a situation where supply always exceeds demand. This means that naked short-selling isn’t just an opportunity to make money from a falling share price, like ordinary short-selling. Instead, it’s a method of making money from a falling share price that, thanks to the way it operates, also guarantees that the share price will continue to fall. Ordinary short-selling doesn’t have to increase market volatility excessively. A significant level of naked short-selling, on the other hand, cannot help but cause the share in question to fall further and faster than it otherwise would have done. (This is a bad thing because rapidly falling share prices can trigger the sale of shares that were bought long (i.e., in the expectation that prices will rise), which can lead to a sustained run on the market.)
The second major problem is that, because the thing being traded is not a real share but only the promise to deliver a share in the future, the actual commodity being traded in is confidence. For a naked short-sale to work, the purchaser has to trust that the seller will deliver as promised. The problem arises because, hidden behind a lot of coded language referring to things like ‘market sentiment’, share traders are easily spooked, and they behave like herd animals – if one starts to look nervous, the others feel even more nervous, and soon a full blown panicked stampede is in progress, even if the first animal was only briefly upset by its own shadow. This reality means that a small loss of confidence can quickly escalate. If there were a catastrophic loss of confidence in the integrity of the stock market – with no-one sure how many shares were real, and how many were fake ones that might never be delivered – the effect would be to drive many investors out of the market altogether, leading to a catastrophic fall in share prices across the board.
It seems that Germany’s attempt to ban naked short-selling has not gone down well with traders. I can certainly understand that this is an area where there isn’t much point in unilateral action – the price of the shares in question on the German stock exchange will be affected by their price elsewhere, and since naked short-selling is not being banned everywhere, that means the price will continue to be affected by the practice. I also understand the argument that, when a hedge fund manager’s ability to go short on certain shares is curtailed, it has an effect on her ability to go long – she can only risk going long on one share to the extent that she can hedge the risk by going short on another – and that this will have a net effect on share prices across the board, and, in the short-term, may even end up causing worse and faster falls in share prices than if a ban had not been imposed.
On the other hand, naked short-selling is one of those things – like betting the entire global banking system on the belief that it doesn’t matter if mortgage customers in America default on their loans because, as the property bubble can never burst, there will always be enough new customers to keep the cash rolling in – that is guaranteed to go wrong at some point. I’m sure banning naked short-selling across the board would have a dramatic impact on the ability of the stock market to generate money for the people who operate in it, but so far as I can see that’s a benefit, not a problem. Allowing naked short-selling to proliferate will allow the stock market to become more profitable, but that just means the inevitable crash, when it comes, will be bigger.
Since it involves selling a thing that may never be available for purchase, the practice of naked short-selling is essentially turning the stock market into a futures market – like, for example, the one where people buy and sell next year’s coffee harvest – and futures markets are known to be inherently risky. That’s why the people who trade in them behave accordingly, insuring themselves off the market for the possibilities of losses on it. A stock market in which naked short-selling has been allowed to develop unchecked would be a futures market in which traders’ only insurance would be their hedged positions on the market. The problem with this is that if – when – the market suffers a catastrophic collapse, both positions will collapse simultaneously. Share dealing, whether long or short, is based on a presumption that shares will change in value, so if shares across the board have been rendered worthless (or so close to worthless that there are almost no fluctuations in value) by a catastrophic loss of confidence in the integrity of the stock market itself, there will be no opportunity to make money either way round.
The stock market will always be volatile, and ordinary short-selling is a way of making sure that the volatility can be turned into a net benefit (at least for the traders). Naked short-selling is different, because it has the potential to undermine confidence in the integrity of the stock market itself. And if you can’t trust the market then you can’t buy or sell – meaning in pretty short order that there’s no market left, even if you wanted to trust it.