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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