by Luis Pablo de la Horra
The recent GameStop controversy has once again turned the spotlight on short selling (i.e., the practice of borrowing a stock you don’t own and sell it on the market). This isn’t the first time. Short selling has been under scrutiny for decades, with many countries imposing restrictions on this practice during periods of economic and financial crises.
Proponents of banning short selling argue that it benefits speculators at the expense of public companies and retail investors. Elon Musk himself has repeatedly called for making such a practice illegal on the grounds that “shorting is a scam”. But should we ban short selling? What would be the consequences of doing so? Does short selling play any important role other than benefiting speculators?
Before answering these questions, let’s briefly summarize the GameStop case to understand why short selling has been on everyone’s lips the past few weeks. Since 2016, GameStop, a video game retailer, has gone through a process of steady decline as a result of its core business (selling video games in physical stores) becoming obsolete. The poor prospects of GameStop, whose stock price has been falling for years, led several hedge funds to short the stock, with the subsequent negative impact on its price.
However, in January 2021, users from a WallStreetBets (a subforum within Reddit) called for retail investors to buy GameStop’s stock, sending its stock price through the roof. And I’m not exaggerating. The price moved from 19.94 on January 11 to 347.51 on January 27, that is, a 1,600 percent increase in only two weeks. Such a drastic change devastated short sellers who had sought to use GameStop’s stock. For instance, Malvin Capital Management, a hedge fund heavily affected by GameStop’s short squeeze, lost 53 percent on its investments in January.
Many in the public square viewed this loss as a harsh lesson for short sellers who are often portrayed in the social imagination as ruthless speculators preying on and profiting from falling stock prices. However, short sellers are much more than simple speculators. According to a recent paper published at the European Accounting Review, they play an essential role in market economies.
After reviewing the existing academic literature on short selling, the authors draw several challenging conclusions. First, short selling improves market efficiency by allowing for (and speeding up) the incorporation of both public and private negative information into stock prices. The evidence suggests that short sellers tend to be better informed than other market players. This superior information allows them to short overvalued stocks, preventing the formation of financial bubbles. Therefore, banning short selling would result in the formation of financial bubbles, one the most common causes of financial and economic crises.
Second, short sellers help improve the quality of financial reporting by public firms. This reduces information asymmetries between corporations and investors. In effect, short sellers tend to target companies with low reporting quality, which incentivizes these companies to improve their reporting standards in order to avoid being shorted.
Short selling also increases stock market liquidity. Because short selling implies selling a stock to repurchase it at a later date, the liquidity of shorted stocks tends to go up, along with the subsequent reduction in transaction costs for investors. More importantly, short selling has been shown to decrease the cost of capital of firms (i.e., their financing costs), allowing them to borrow more cheaply in the financial markets.
In addition, short selling imposes constraints on CEOs, increasing the likelihood of forced CEO turnover. As we said above, short selling quickens the incorporation of negative information into stock prices. This may result in CEOs stepping down or being removed by shareholders as a consequence of stock prices going down. By keeping CEOs honest, short selling incidentally reduces stock market volatility.
In sum, the evidence presented here suggests that the effects of short selling are overwhelmingly positive. As shown, such a practice enhances market efficiency, incentivizes public firms to improve their reporting standards, increases stock market liquidity while reducing volatility, curbs borrowing costs for firms, and reduces agency costs of firms by imposing constraints on CEOs actions.
The GameStop controversy may lead political authorities to implement new regulations in financial markets. But banning or imposing restrictions on short selling shouldn’t be one of them as it would certainly cause way more harm than good.
Luis Pablo de la Horra is a Ph.D. candidate in economics at the University of Valladolid. His work has been published in several media outlets, including The American Conservative, CapX and Intellectual Takeout.