Villains or saviors of market?
Should short selling be subject to tougher regulations?
By Chung Hee-hyung
Lee Kun-hee, chairman of Samsung Electronics, lost 1.5 trillion won ($ 1.4 billion) in two months when the share price of the company plummeted by more than 17 percent from May to June.
Lee managed to remain the richest man in Korea, but the loss of an average of $24 million per day stunned market watchers, prompting them to speculate as to the possible cause of such a dramatic drop in the share price.
Investor anxiety surrounding the eurozone financial crisis was partly responsible for the dramatic fall, but a hitherto obscure investment strategy emerged as another likely culprit as well ― short selling.
What is short selling?
Normally, investors bet on a rise in a company’s stock by buying them at a low price and selling them later on when the share price goes up. Short selling stands in the exact opposite; it profits from a fall of share price by borrowing stocks first and then selling them when they are still running high with the expectation that the price will eventually go down. When the stock does fall, the investor buys them back and returns them to the lender. It is essentially selling something at a high price and buying it low later on.
Although the strategy may look somewhat unfamiliar, short selling has been practiced for more than 500 years, and its history is as old as that of finance itself. In 1609, a Flemish merchant who was also a former board member of the Dutch East India Company expected depreciation in the company’s stock.
He formed an alliance with like-minded short sellers and contracted to sell large amounts of the company’s shares, which sent the shares of the company into a steep dive.
The Dutch Easy India Company was outraged, and persuaded the Amsterdam Exchange to impose a ban on the practice. It was the world’s first recorded ban on short selling.
A short story about short selling
Ever since the Dutch merchant’s episode, short sellers have always been the targets of blame in times of financial crisis. Authorities imposed strict regulations and sometimes outright bans on short selling whenever stock markets plunged.
President Herbert Hoover railed against short sellers when some Wall Street executives shorted on their own stock in the midst of the Great Depression.
The government launched a congressional investigation and eventually introduced the Banking Act of 1933, more commonly known as the Glass-Steagall Act.
It was the first comprehensive regulation on financial speculation in the U.S. However, it was certainly not the last. As recently as 2008, a strict ban on short selling was again put in place when short sellers were accused of precipitating the bankruptcy of Lehman Brothers.
“The Securities and Exchange Commission has made plain that it has zero tolerance of naked short selling,” said Christopher Fox in 2008, chairman of the SEC at the time. “In order to ensure that hidden manipulation, illegal naked short selling, or illegitimate trading tactics do not drive market behavior and undermine confidence, the Securities and Exchange Commission today took several actions to address short selling abuses.”
His rail against short sellers was echoed across the Atlantic, and German Chancellor Angela Merkel called for stricter regulation of international hedge funds, which does most of the short selling. “It is a scandal that hedge funds are not regulated,” said the Chancellor when announcing a ban on short selling in 2010.
Strictly speaking, the chairman of the SEC and the German Chancellor were only referring to ‘naked’ short selling wherein a seller sells his shares without even borrowing them. The ‘sell’ only exists as credit, and it is considered more speculative and potentially dangerous than ‘covered’ short selling in which a seller borrows stocks (usually from brokers) before selling them in the market. In other words, they were not banning short selling per se; investors were permitted to engage in short selling as long as they covered their short positions with borrowed shares.
However, regulators in Korea seem to have an even more stringent view against short selling. “We will employ stern measures against those investors whose manipulative behavior through short selling has the effect of disrupting the market,” said Kim Seok-dong, chairman of the Financial Services Commission (FSC) in May. “We cannot let the stock market collapse by such speculative practice.”
Korea, in fact, has fairly strict regulation on short selling. Naked short selling is banned outright, bar a very small number of exceptions, and for financial stocks, even covered short selling is not permitted. Nearly 80 percent of short selling is made by foreign investors, with domestic institutional investors taking the most of the remaining one-fifth.
Technically, individual investors are also eligible to borrow shares for short selling. But stringent depository requirements and other regulatory strings attached mean that few are willing or even able to take part in the investment.
Finding the naked truth: is short selling good or bad?
When investors bet on a rise of a company’s shares and make money as a result, they are lauded for their foresight. However, fewer praise them, if they predict stocks to fall, sell those stocks and then make a profit by purchasing them back at a lower price. It is O.K. to share in a company’s success, the reasoning goes, but not its failure.
Advocates of the practice, however, protest that they are carrying disproportionate blame for drops in share prices. “Everyone blames short sellers for causing the stock market to plummet, but few empirical studies support such a notion,” said Kim Joon-seok, a research fellow at Korea Capital Market Institute.
“The undue negative publicity has led ordinary investors into believing that there is nothing good about short selling. In fact, it is a perfectly legitimate investment strategy. One is surely entitled to make money when you correctly guess that the market will go down.”
Moreover, the matter is not simply rewarding foresight. Despite the image of the hedge fund, villains greedily putting money in their pockets when everyone else is suffering from loss, it serves several useful functions, critics argue.
“Short selling is important for price discovery,” Kim noted. “Short sellers have a strong incentive to find and dig up bad information, because they are in a position to benefit from it the most. Although that notion may seem repugnant, it actually sheds light on crucial pieces of information that otherwise may not be available.”
Jeremy Stein, professor of Economics at Harvard University, expressed a similar view. “Constraining short selling in fact allowed stocks to become more overvalued in 2003,” he wrote in the wake of the dot-com bubble that is now widely interpreted as a precursor of the much worse financial crisis five years later.
Moreover, accusing short sellers of bringing the stock market down is confusing cause and effect, noted Choi Chang-kyu of Woori Investment & Securities.
“Most price falls are the result of panic selling by ordinary investors, not alleged speculation by short sellers,” Choi said. “It may add momentum to drops in prices, but short selling in and of itself does not start them.”
Most crucially, short selling plays a significant role in identifying overpriced stocks, and short sellers in effect act as whistle blowers. In good times, few investors would bother to carefully scrutinize a company’s balance sheet and look for any potential pitfalls that may give a warning sign. Few, of course, except for short sellers.
In late 2000, when everyone was praising Enron’s brilliant success, hedge fund manager James Chanos discovered that the company’s accounting practice grossly overstated its earnings. For instance, the company created a partnership firm _ existing only on paper _ and dumped Enron’s liabilities in the partnership book. The liabilities, of course, were not reflected in Enron’s financial statements.
He also found that the actual return on capital investment was worryingly low, and that whatever rosy prospect the company’s financial statement suggested was not sustainable.
Chanos concluded that the stock of Enron was vastly overpriced and increased his short position accordingly, but others were not so prescient. It was only after more than 20,000 of its staff lost their jobs overnight that the authorities discovered the company’s countless flaws hidden in its financial statements. Chanos was belatedly commended for his early awareness of Enron’s problems.
Moreover, short selling does not always bring prices down. Short sellers should eventually buy back the sold stocks, and this could act as a break in a down market when every other investor is selling their shares in panic.
Not so good after all
Critics of short selling concede that betting on a down market does serve several important functions, at least in theory. But they point out that such supposedly positive does not hold true in Korea. Its finance market is far less sophisticated than developed countries to enjoy the full benefit of short selling.
“In Korea, foreign investors, mostly hedge funds, wield disproportionately large influence over the country’s stock market,” said Park Yun-bae, the president of Seoul Invest, a local private equity fund.
“Whenever they find a target, foreign investors go on for a massive short selling of a particular stock at a particular moment. The price of the targeted stock then drops dramatically and domestic investors have few means to stem the tide.”
Park said that foreign investors may even deliberately distort prices by spreading false information. “The saga of Celltrion is case in point,” noted Park. Indeed, the story of Celltrion, Korea’s leading biotech company is a textbook example of how short-selling can be abused when put in the hands of the wrong investors.
In April last year, a rumor circulated in the market that two patients died while taking part in Celltrion’s clinical trial for a breast cancer drug. Celltrion’s stock dropped more than 3 percent in a single day, and numbers showed who was behind the scene; the portion of short selling in Celltrions’s overall stock transaction in May amounted to 13.6 percent, more than three times the normal level. In all, short sellers sold more than 8 million shares in 2012 alone.
As if this attack was not enough, they continued to unleash a steady stream of bad news for more than a year, prompting the company to act in a dramatic response.
“We are entering the most critical phase of the war against short sellers,” declared a notice put on the company’s website in early May.
Fortunately, the company had enough cash or “live ammunition” to fight back against its enemy. It purchased a larger amount of its own shares to push its price upwards, forcing short sellers to buy back its sold shares at a higher price. In a similar move, Celltrion issued one bonus shares for every two stocks already owned by its shareholders.
A bonus share is free stock given to shareholders in proportion to their stake in the company. The company pays for the bonus shares out of its retained earnings with no charge to the shareholders, so normally it should come as a pleasant surprise to them.
But this is not an experience matched by the short sellers. Now they have to buy back one additional stock for every two shares it initially borrowed and sold afterwards, because the brokers who lent the original shares had a right to the newly issued bonus stocks as well. It was akin to repurchasing the company’s stock at a 50 percent higher price, and this led to staggering losses. Celltrion’s move put an end to the downward spiral of its share price. The market capitalization came back to 5 trillion won ($ 4.5 billion) in May for the first time in seven months.
Celltrion’s story ended with a happy ending. But the country’s fragile stock market means it could be subject to similar market abuse at any moment.
“It is not feasible, of course, to totally ban short selling. It is neither desirable nor very realistic,” admits Park. “But the financial authorities should maintain at least some degree of control until Korea’s stock market matures enough. Enough, that is, to withstand the disruptive effective of short selling on its own.”