02 Nov 2017
As illustrated in Figure 1.1 and its subsequent explanation, apart from the ultimate stock buyer, a short sale transaction mainly involves three participating groups; stock lenders, short sellers (stock borrowers) and brokers (intermediaries).
D’Avolio (2002) states that in the US markets, custody banks such as Bank of New York [1] or State Street Bank act as the largest stock lenders. These banks act as an intermediary for mutual funds, pension funds and insurance companies who are considered to endorse "long duration, buy and hold investment" strategies.
Brokers act as an intermediary to facilitate the stock lending and borrowing process. In a short sale transaction, the broker would be approached by the short seller; with the latter requesting the broker to ‘locate’ the stocks to be short sold. As Duffie et al (2002) describe, the search for the stock can be conducted via an "electronic locate system" or through traditional communication system such as email, telephone or fax. Moreover, Duffie et al provide different approaches a broker can undertake to locate the stock.
The first approach is for the broker to locate stock from its own inventory or from its customers’ accounts. The next alternative approach would involve brokers contacting large institutional investors directly or through custodian banks. In this regard, Duffie et al state that brokers and institutional investors may even enter into exclusive contracts, enabling brokers to access and lend the institution’s portfolio of stocks [2] .
Although different factors could influence who acts as a short seller, the following are generally considered to be the main short sellers in every stock market.
Hedge funds
Even though not all hedge funds engage in short selling, hedge funds are considered to be the most active practitioners of short selling. These hedge funds normally use long/short strategies whereby short sales are used to partially cover long positions. This strategy allows hedge funds to ensure a continuous stream of returns, irrespective of any market conditions. Besides long/short strategies, hedge funds such as James Chanos’ Kynikos Associates are famous for specialising solely in short selling strategies.
Market makers
To execute customer orders when liquidity is insufficient (or low), market makers may engage in temporary short positions. For this reason, most of the recent regulations related to short selling do not apply to market makers.
Investment banks
Negative predictions about a particular company may induce Investment Banks to engage in short selling as part of their proprietary trading strategy.
Diether et al (2009) state that speculation; hedging and arbitrage are the main motivations that may induce traders to engage in short selling. Moreover, market making and taxation may also feature as additional motivations for short selling.
When traders consider particular stocks as overvalued, short selling provides a means to speculate/profit from the decline of such stock prices. Thus, speculative short selling requires constant monitoring for companies that may seem to be mismanaged or facing possible future problems. Chapter Two has already highlighted some ethical concerns related to speculative short selling, particularly the possibility of benefiting from the misfortune of others.
Market players, example hedge funds, can reduce the risk emanating from the market (market risk) by simultaneously holding long and short positions in the same stock.
When stock index futures contracts are considered to be cheap when compared to the underlying stock’s value, Index arbitrage can be achieved by shorting the stocks forming the index whilst buying the index’s futures contracts. As the futures approach expiration, price differences will narrow and a profit can be made irrespective of price movement’s direction.
Semi-Strong market efficiency predicts that when a merger announcement is made public, the target company’s stock price would increase whilst the acquiring company’s stock price would decrease. Thus, traders seeking to profit from such price differences will buy (go long) stock of the target company and simultaneously short sell stock of the target company. One must however consider the inherent risks where, for several reasons, merger deals may not materialise or complications arise [3] .
As already stated, market makers may resort to use short selling (even naked short selling) to meet customer orders. Thus, due to the relative urgency to complete transactions, market makers can be assumed to disregard whether stocks are overvalued or not (unlike speculative short selling). The UK’s Financial Services Authority (FSA) considers the activity of market makers as an important provider of liquidity in financial markets.
Prior to the Taxpayer Relief Act (1997) in the United States, shorting against the box was a short selling strategy aimed to defer taxable gains.
"Delaying the recognition of a gain is particularly important if the investor will be taxed at a lower rate in the subsequent tax period." (Brent et al 1990, p.275)
This could be done by holding long and short positions in the same stock, with the short position not being covered. Contrary to a normal short sale, traders in shorting against the box transactions were not negatively exposed to the stock. However, the elimination of the tax benefits made this trading strategy more expensive with Arnold et al indicating that shorting against the box declined in popularity and use following the enactment of the Tax Relief Act of 1997.
As a market practice, short selling carries specific risks not associated with the more common and traditional form of trading, i.e. holding long positions.
Short sellers face the risk of unlimited losses as stock prices have no upper limit that can be reached. Brent et al (1990) suggest that risk averse and less experienced investors may find the unlimited loss potential undesirable and that buying put options may be a more valid alternative for such investors.
The stock lender reserves the right to recall the borrowed stocks at any time. Thus, the short seller faces the risk of not yielding any benefits from the short position. D’Avolio (2002) indicates that two choices are available for the short seller; either covering the short position or renegotiating the stock loan. The latter alternative is considered to be complicated and renegotiated terms may reduce short sale profits due to higher loan fees. The other option (buy-in or forced covering) entails buying the stock back and returning them to the lender, where losses can be made if the repurchase price is higher than the original short sale price.
Moreover, due to the inability to close out the position, short sellers may end up in a ‘short squeeze [4] ’. For this reason, short selling is generally effected where there is sufficient liquidity, thereby reducing the risk of a short squeeze.
Following the market decline in 1937, the Securities and Exchange Commission (SEC) introduced the ‘uptick rule’ for stocks listed on NYSE and NASDAQ. This rule practically allowed a stock to be sold short only if the latest price change of that stock was an upward movement. Thus, short selling would be prohibited if stock prices were going down.
The SEC removed the uptick rule in July 2007, on the basis that the restriction reduced liquidity and did not prevent manipulation.
Four months later, in November 2007, Citigroup was allegedly the victim of a ‘bear raid’. Misra et al (2012) claim that such market manipulation would have not occurred had the uptick rule remained in force.
As a result, widespread calls for the reintroduction of the uptick rule were made and in 2009, SEC started public consultations in a bid to reintroduce a variation of the uptick rule.
The modified uptick rule, adopted in February 2010, would act as a ‘circuit breaker’ to ban short selling in case a stock’s price falls by 10% in a single day. Misra et al define the new rule as "weaker" than the previous one and state that it would not have been of any use in the case of Citigroup, where prices only fell by 9% in a single day.
From the above analysis, it is clear that although short selling can be a profitable and useful investment strategy, one must also consider the risks associated with such market practice. In this regard, one may argue that James Chanos’ statement that "short selling has risks and costs because we are often swimming against the tide and may face unlimited losses if our analyses prove wrong" seems to suggest that, due to the precise market timing required, only skilled and experienced investors may succeed in short selling.
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