Congress and the SEC Should Not Tax and Regulate Short Selling

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Posted by Dan Kim on Friday, April 30th, 2021, 11:14 AM PERMALINK

The recent Reddit-fueled GameStop stock surge shined the spotlight on the investing strategy of short selling. While Congressional Democrats were quick to single out short sellers as one of the villains in this story, their push to impose new regulations and taxes is a solution in search of a problem. 

The truth is, short sellers are a product of a well-functioning market. Lawmakers should reject any effort to restrict or ban short selling.

To sell a stock short, investors borrow shares of a company from another investor, typically broker-dealers. Short sellers then sell the borrowed shares directly on the market. Later, when the borrowed shares must be returned, they repurchase the same number of shares borrowed and return them to the broker. Instead of buying low then selling high, short sellers’ profit from the difference when they sell high and then repurchase low. 

There is nothing sinister about this practice. Instead, it occurs when investors believe that a company is overvalued. 

Following the GameStop rally and the media’s focus on the story, Sen. Elizabeth Warren (D-Mass) issued a statement condemning the “casino-like” speculation done by short sellers and demanded SEC involvement. The House Financial Services Committee also hosted two separate hearings on the practice of short selling. These concerns are misguided.

Short selling can soften the effects of a market crash. Despite the left's effort to convince the public otherwise, short selling is not responsible for market crashes and economic downturns. Some investors will short a stock when they think it is overvalued. Other investors, as shown as the recent rallies in GameStop and other companies, will buy a stock they think is too heavily shorted. Both practices help promote efficient investing and provide information to markets, ultimately softening the blow of a downturn.

For example, the 2008 market crash could have been far more widespread if short sellers hadn’t recognized the housing market was overvalued. Arbitrarily restricting this trading through new taxes or regulations will likely lead to severe pain if the country experiences another crash.

Short selling can expose fraud which others failed to find. Short selling serves a market purpose -- the work of short sellers incentivizes the discovery of significant fraud that financial auditors and regulators fail to find. Economists have shown that information from short sellers support price discovery within markets, which helps educate investors.

Short selling has been used to expose fraud and illegal activity on numerous occasions:

  • Jim Chanos, president of Kynikos Associates, notably profited from shorting Enron after observing significant insider selling and reading through questionable energy trading contract disclosures in regulatory filings.

  • Nate Anderson at Hindenburg Research published a short report raising concerns about claims the electric car manufacture Nikola was making and their ability to timely produce vehicles. His research included gathering recorded phone calls, text messages, private emails, and behind-the-scenes photographs to highlight dozens of false and misleading statements made by Nikola and its founder Trevor Milton. 

 

  • Muddy Waters Research’s Carson Block sold short the fraudulent Chinese café chain Luckin’ Coffee after analysts recorded over 10,000 hours of store traffic video and found that Luckin inflated its revenue numbers based on customer traffic that did not exist.

Short selling comes with significant risk, just like any other investment. Far too many politicians refer to short selling as predatory, with an inevitable profit to be made on the backs of others. This is entirely misguided. Just like other investments, short sellers are taking a significant risk. 

During the GameStop rally, Melvin Capital lost almost $6 billion in capital from its short position. Investors who bet against Tesla in 2020 lost $38 billion as the electric carmaker’s stock surged during the pandemic.

Additionally, short sellers' careers depend on them remaining credible; otherwise, their research reports and disclosures would not be taken seriously. Thus, concerns about purely predatory short selling, and the success of those endeavors, are empty. 

Short sellers provide value to the market by investigating corporate malpractice and fraud and should be welcomed as a third-part check for healthy markets. In other words, short selling is a feature, not a bug, of a well-performing market.

Congress and regulators should refrain from restricting or banning short selling, they harm price discovery mechanisms and interfere with market due diligence.

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