Short sellers are like sharks that prey on the weak. However, with the rise of self-media, big data, and program trading, short selling now faces regulatory challenges.

Author: Jack Yang

Wall Street veteran

Huishan Dairy’s recent cash flow crisis and stock plunge have reignited discussions on short selling. Short selling originated from the Amsterdam Stock Exchange in the seventeenth century, not long after the exchange was established. Since short sellers bet on, and profit from, a drop in a security’s price, they have been likened to someone who “kicks his targets while they are down,” a morally charged accusation that frequently ignores their positive role of stabilizing the market.

Short sellers are like sharks – merciless predators, yes, but also housekeepers that keep the ecosystem healthy. They often go after the weakest of the bunch, most of whom are in that position because of flaws in their business models, competency, operations management, and information disclosure.

This is best illustrated by the Enron scandal. In early 2001, American short seller Kynikos Associates alleged that Enron, then the largest American energy company, inflated profits with mark-to-market accounting, hiding huge losses in shell companies. Under overwhelming pressure, Enron later admitted to misrepresenting profits of nearly $600 million since 1997. Less than a year later, Enron, once valued at $80 billion, declared bankruptcy with several of its executives sentenced for financial fraud. In a similar vein, the author once questioned a high-tech listed company for being coy about its purported core technologies that made it a favorite among investors. When the charade was exposed, the company lost more than 90% of its value within a year.

Often targeting unsound or overvalued companies, short sellers drive down their stock prices to a rational value. Since they often have a narrow range of targets, the negative impacts of short selling on the stock market are limited. In the US, shorted stocks make up only a small portion of the stock market. NYSE once looked into more than 8,000 stocks and found that only 4.3% of the total shares were shorted, and only 48 stocks saw over 30% of their floating shares being shorted.

Therefore, short selling can help validate the prices of listed companies. It also contributes to a more balanced trading structure. In the absence of a healthy short selling market, investors can only profit from price increases, which encourages irrational investment behaviors.

In a long-only market, investors tend to overreact to good news and worship future returns while underestimating downside risks, leading to a systemically overvalued stock market. In addition, this type of market environment encourages management teams to exaggerate current and future performance and to hype the potential of their companies. This, coupled with the long-only mindset of investors, creates a positive feedback loop that entices investors to invest in an already overheated market or even take on higher leverage, quickly creating a stock market bubble.

A September 2015 report from Tsinghua University National Institute of Financial Research argued that domestic restrictions on short selling were partially to blame for the then overheated A-share market. In fact, short selling only accounted for less than 1% of all borrowing activities (either margin trading or short selling) in the A-share market, much lower than the 30% figure in the US. In June 2015 in the A-share market, the balance of margin trading was 560 times that of short selling, and more than half of the RMB 5-6 trillion total market inflows that month came from illegal financing at a leverage ratio as high as 5-10.

Of course, short selling also has its cons. Without adequate regulation, it may even undermine the soundness of the capital market. Generally, a short seller first identifies weaknesses in a target company, establish a short position, and publish a research report pointing out the perceived issues, making a profit from the subsequent falling stock price. In most cases, the price would fall as soon as this report is released – often times calling the short-selling company into question whether the report is sufficient to produce the desired outcome, while the accused has to come up with evidence to defend itself. Even if the allegations are unfounded, the target stock would still experience a downward pressure for some time. Some short sellers even put out pessimistic views or false information during trading hours to deny the target company the time to respond, so that they can profit from the intraday price fluctuations.

The rise of self-media, big data, and program trading creates additional opportunities for wrongdoing. Some trading software works by analyzing online news reports and counting the number of keyword hits, without verifying the validity, rationality, and timeliness of information. Malicious short sellers can abuse this flaw of design by widely disseminating outdated negative reports, faulty analysis, or even lies to trigger the software’s pre-set conditions. This type of bad faith short selling more commonly targets stocks with a high proportion of retail investors. Without proper regulation, it may spread across and disrupt the entire market.

Retail investors constitute the vast majority of China’s A-share market. As such, more rigorous regulation is required before short selling can be permitted on a larger scale according to a well-paced timetable.

From: Caixin Weekly, Issue 18, May 8, 2017