How Short Sellers Become Targets During Market Routs

(Bloomberg) -- When stock prices plummet in a market rout, short sellers often become a target. Regulators can attempt to curtail the plunge by restricting equity short selling, or betting with borrowed shares. Shorts, as these bettors are known, say their trading helps keep markets functioning smoothly. Critics say their actions can blur into market manipulation. During periods of acute market distress, such as early in the coronavirus pandemic, some of the hardest-hit countries again imposed temporary bans -- although to what effect is unclear.

1. How does short selling work?

Short sellers borrow shares and sell them, hoping to buy them back at a lower price to profit from the difference. But getting the timing right is crucial. If the stock price rises, they could lose money instead.

2. Who are the short sellers?

Most shorting is done by hedge funds and institutional investors to cushion their investments or to bet that shares have risen too high. There are also so-called activist shorts, who research companies to find targets that they allege have dodgy business or accounting practices, spread the word (sometimes anonymously) and, if all goes as planned, watch the stock slump. Many authorities dislike short selling. The former head of the New York Stock Exchange has described the practice as “icky and un-American.”

3. Is short selling illegal?

It’s legal in most major stock markets, though some may issue temporary restrictions during periods of market turmoil. Short selling was already under attack before the stock market started tanking in February. French politicians prepared a report last year on ways to rein in short sellers and activist investors, and German authorities began an investigation into speculators who criticized the accounting of payments company Wirecard AG. What is banned either partially or fully in several markets is so-called naked short selling -- betting on a stock’s decline without having first borrowed the shares.

4. How was short selling restricted?

Six European countries -- France, Spain, Italy, Belgium, Greece and Austria -- banned short-selling in March when regulators said such trading could exacerbate the steep declines in equity markets. The bans, which had been strongly opposed by hedge funds, proprietary trading firms and Germany’s primary exchange, ended May 18 in a coordinated move and are not being renewed. South Korea has banned short-selling of shares in the benchmark Kospi index, tech-heavy Kosdaq index and small-cap Konex from March 16 to Sept. 15. The European Securities and Markets Authority, which oversees standards across the bloc and had ordered hedge funds and other traders to disclose more information when they bet that stocks will decline, said it will continue to require increased disclosure of short positions until at least June 16.

5. Did it work?

It’s hard to tell what would have happened without the bans. Regulators in France and Italy said they aren’t needed any longer because trading has become more normal. While volatility is higher than it was in February before the virus outbreak in Europe, France’s Autorité des Marchés Financiers said this is more a reflection of traders’ uncertainty about the future. AMF Chairman Robert Ophele said in a Bloomberg TV interview that the restrictions “didn’t have any detrimental effects” on the market and he looks forward to subsequent research on the effect of the bans, which covered markets hosting 60% of trading in the euro zone.

6. Has this ever happened before?

Oh yes. The U.S. targeted short selling during the Great Depression and joined the likes of the U.K., Germany and Japan in limiting short selling or banning it in 2008 during the global financial crisis. China’s regulator blamed “malicious” short selling in part for a stock market crash in 2015, placing limits on the practice as well as arresting traders.

The Reference Shelf

• A QuickTake explains the history of short selling, and the debate about “activist” shorts.
• Michael Lewis’s definitive take on the financial crisis, “The Big Short,” is also a movie starring Christian Bale, Steve Carrell and Brad Pitt.
• A Bloomberg article says short sellers made over $50 billion during the recent coronavirus sell-off, and another on a $14 billion bet by Bridgewater Associates, the world’s biggest hedge fund.
• A study commissioned by the London Stock Exchange found that market liquidity declined in banned stocks compared to control stocks in the period after short selling was banned on selected financial and insurance stocks in September 2008.

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