Why a short-selling ban won’t work

Tim Bennett explains the practice of short selling shares – and why a ban may do more harm than good.

Short- selling: should it be banned, is there any point in banning short-selling? Tim Bennett argues that no, there isn’t, as it does more harm than good.

Short-selling is when someone who claims to be short in the market, or short-selling, is betting on something, whether that is a share or commodity, that is falling in price.

You can make money, in theory, by selling something or a high price, then buying it back later at a lower price.

How does short-selling work?

In a simplified version: take a hedge fund (the borrower), and a pension fund (the lender).

  1. The hedge fund borrows 10,000 shares from the pension fund, with the agreement that the hedge fund will pay a fee for lending the shares.
  2. The hedge fund, with the shares, sells them at, let’s say £2 each, in the stock market.
  3. The hedge fund waits until the price has fallen, then buys the shares back at, say £1 each.
  4. The pension fund gets its 10,000 shares back plus the lending fee. These don’t need to be the same 10,000 shares, as long as it’s the same number of shares.
  5. If prices fall and the hedge fund makes the profit of £1 per share, it’s made a profit of £10,000, minus the lending fee.

Why ban short-selling?

Four countries’ regulators have agreed that this needs to be banned – France, Spain, Italy and Belgium. They can’t have hedge funds betting on bank shares falling in prices using short-selling. They’ve tried to introduce a temporary ban, on certain stocks they have nominated.

Are these countries right to ban short-selling?

No, there are two problems:
1. The way it has been implemented is flawed

The mechanics don’t work: four countries will outlaw this practice, because it drives down share prices. They accuse hedge funds of betting on prices falling, and therefore accentuating the falling prices of certain bank stocks. Will it work?

It’s only a partial ban across four countries, so some hedge funds will simply move to jurisdictions that haven’t banned short-selling. Equally, only banning a few stocks will just target the short sellers’ attention on the other stocks.
Also, what is going to be banned? You can’t ban short-selling via shares, because of derivative contracts that allow people to short sell. Is it enough to just ban short-selling of shares, or do they need to widen the ban, and to cover what?

2. The principle of banning short-selling is wrong.

Short-selling is risky, and if it backfires, the people who do it pay a hefty penalty.

In the example above, if the price doesn’t fall, and the price doubles, you would have to buy the shares back at a higher price, and this could take a long time to find someone to buy these shares back from.

Short sellers have a good reason to do what they do: if a share price is falling, it’s not due to short sellers, it’s due to the bank being badly run. And if you ban an activity that lots of people use in the markets as a trading tool, you reduce the number of trades and increase volatility.

The point of a short-selling ban is to stop share prices falling, but it doesn’t work: hedge funds need to be able to run long and short positions, in order to hedge existing exposures.

Sometimes the motive behind short-selling is simply hedging, which is something a lot of funds need to be able to do. Closing that down, effectively makes the market less efficient than it should be.

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  • rob

    Very good info.Just some advise.. fine lined pattern shirts and video do not go well together.. moire effect.. quite distracting.. plain blue shirt is good for video..

    Sorry to be picky ..

  • Jaygor

    Thanks. Tim. This is the clearest explanation I`ve ever received on how short selling works and why baning it is ineffective and wrong-headed, anyway.

    Will the politicos in the EU listen? I doubt it. Even banging their heads together wouldn`t do it.

    Let them sort out the mess they are in by themselves. We are well out of it. Let`s stay out of it.

  • JRET

    Great video – as are all yours! What happens to the dividend? Does the leander get the shares back before they go ex-dividend?

  • Al

    A simple and clear explaination, this guy should have his own TV series.

  • Jo

    Nice presentation – but I suspect an degree of obfuscation. Hedge funds and the like CAN instigate and exasperate a run on a stock that maybe OR may NOT be a risk. After all it is in the Hedge funds / speculators interest to sniff out opportunities whether they exist OR there is a just a rumour that it exists. Certain institutions/funds are influential enough to instigate a lack of confidence by proxy.

    You are right that a partial ban is stupid. Therefore it must be across the board. When it comes to derivatives, it matters not. An international across the board filters through the purposefully complex web of deceit that are CDO’s.

  • Jim

    Very interesting.

    It makes me wonder why governments do ban it. They are receiving information about short selling from advisers. So is it the fault of the advisers?

    Of course the next question has to be “who are the advisers”, they wouldn’t be bankers would they?

  • Tim

    Jim. It comes down to governments being seen to “do something” (however pointless) when markets fall. Pity they don’t feel the same need to act to stop bubbles building in the first place!

  • Andreas

    Good video. Agree with your arguments.

    Would love to see one with arguments around naked short selling. I can’t understand why that is allowed, but as it is in most countries, there must be some pro arguments.