In praise of social bandits
Marco Sciarra was a Neapolitan bandit of the late 16th Century. He described himself as an envoy of God against usurers and the possessors of unproductive wealth. Short sellers make improbable folk heroes, scourges of big business and the banking industry, or defenders of the disinherited and the dispossessed. But this is only because centuries of establishment propaganda have demonized short sellers as the most antisocial of all capitalists: ones that add nothing to the general stock of wealth but succeed somehow in taking large amounts of it off that most desirable of political and corporate constituenciesthe faithful, long-term investor. The truth is more interesting than the myth. Short sellers have far more in common with Marco Sciarra than any of the hypocritical politicians and self-satisfied bureaucrats that are behind the regulation on short selling issued by the European Commission on behalf of the European Parliament and Council in September last year, and which is now approaching the apotheosis of being voted into law. The principal ambitions of this legislative proposal are to codify the wide variety of restrictions on short selling imposed by European regulators at the height of the financial crisis in September 2008. If passed, it will create new powers to restrict short selling on a Europe-wide scale, ban naked short selling altogether and force investment banks and fund managers to disclose to regulators any net short position that exceeds 0.2% of the share capital of the issuer and make known to the marketplace any net short position that exceeds 0.5% of share capital.As even the framers of these proposals concede, the technical case in favor of short selling is invulnerable. Practical experience of dozens of bans on short selling over hundreds of years, including the wide variety imposed (and indeed not imposed) by regulators all over the world in 2008, has proved that the practice is essential to market liquidity. Where short selling is banned or restricted, trading volumes diminish, bid-offer spreads widen and price volatility increases. A string of academic studies has added only statistical rigor to this obvious empirical fact. The deleterious impact of restrictions on short selling is so well-understood that even the authors of the European Commission proposal itself accept short selling contributes to the efficiency of markets, and increases market liquidity, and that any measures that are enacted by national governments at its behest as a result should not undermine the benefits that short selling provides to the quality and efficiency of markets. Yet a recent study by consultants Oliver Wyman of the likely impact of increased disclosure requirements proposed by the European Union predicts that they will reduce the volume of trading activity in affected stocks, increase the volatility of prices, increase the reporting burden on fund managers, decrease the willingness of corporate executives to meet fund managers and divert investment and trading capital from Europe to Asia. If this last trend persists, it will make it harder and more expensive for European companies to raise equity capital. But the likely consequences extend beyond issuers to shareholders. Whether institutional or retail, they face increased trading costs and mark-to-market losses, a reduced ability to hedge the risk of long positions, an increased risk of falling victim to a short squeeze and a straightforward loss of revenue from lending stocks as short positions are curtailed. True, the Oliver Wyman study was commissioned by one interested party (AIMA), funded by another (Deutsche Bank) and based on a mixture of interviews with a third (hedge fund managers) and data supplied by a fourth (Data Explorers). But an idea should be judged by its enemies as well as its friends. Chief among the opponents of short selling are that breed of politician that believes a country must not only have a large manufacturing sector, but must manufacture certain classes of products, such as airplanes and motor cars; that the purpose of economic activity is not consumption but production; and that it is the role of governments to determine the economic structure of the country, and to formulate industrial strategies to that end. It is not surprising that trade union leaders and CEOs of large corporations are apt to applaud reasoning of this kind, though it is based on economic fallacies of the most primitive kind, for their own interests lie in insulating the status quo from the potentially destructive effects of competition for capital. After all, a short sale is one way of saying that other managers and workers could make better use of the capital. There is opportunism at work as well. It is not surprising that politicians institute bans on short selling whenever a market crashes. Their alternative is to confess that they have mismanaged monetary policy (and in all likelihood fiscal policy as well). Likewise, the CEO of a large company is naturally disinclined to believe that a plunging stock price has anything to do with his or her mismanagement of the assets of the company. As Gordon Gekko famously pointed out in that compelling depiction of an AGM in Wall Street, corporate CEOs have an unhappily long track record of mistaking the resources of the company for their own. Many end up as latter-day possessors of unproductive wealth of the kind that Marco Sciarra sought to repossess in early modern Italy. Sometimes, of course, they are worse than that. But it is short sellers who have the strongest incentive to uncover fraud, accounting problems and other irregularities at large corporations. Regulators and central bankers know all this, of course. But they also know who their paymasters are, and who allocates jobs in the regulation business. In fact, the Oliver Wyman report includes a revealing remark made to a journalist by Martin Wheatley, the CEO of the Hong Kong Securities and Futures Commission (SFC), who will join the Financial Services Authority (FSA) in London in September this year as managing director of its consumer and markets business unit. There is always a problem when regulation is politicized, he says. You get an odd outcome then. Regulation should be pragmatic. Regulators are really technocrats who take account of predictable outcomes. When they have to respond to political pressure, you get a different result. Though politicians are always on the lookout for a scapegoat on to which the voters can heap their sins and those of their elected representatives, it is easy to forget that the political pressure does not stem from voters alone, especially in advanced democracies governed by financial-political elites of the kind that now run the United States, the United Kingdom and most of the major states of Western Europe. John Mack, the former CEO and current chairman of Morgan Stanley, achieved a certain notoriety in this respect. It was on Sept. 17, 2008, that he, as CEO of the largest prime broker in the business, told staff that short sellers are driving our stock down and that he and his senior colleagues were taking every step possible to stop this irresponsible action in the market. Those steps included pressing the Treasury secretary and the chairman of the SEC to do something about it, and short selling of financial stocks was duly suspended 2 days later. The implication that short sellers were the proximate cause of the financial crisis, rather than balance sheets leveraged 30 times or more to acquire oceans of low-quality structured credit manufactured for little purpose other than its financeability, was obviously convenient to all parties. As it happens, far from driving stocks daily to new lows, we now know that hedge funds were actually net buyers of equities in the weeks immediately prior to the collapse of Lehman Brothers on Sept. 15, 2008.Ironically, given the willingness of even senior public officials to make substantial policy changes on the basis of unsubstantiated claims of the most outlandish kind, it is one of the stated purposes of the European regulation on short selling to increase transparency. Yet forcing short sellers to disclose their positions might actually have the opposite effect. Where short selling is not deterred altogether, it will assume synthetic forms, or gravitate to less onerous jurisdictions. It will in all likelihood reduce the quantity of information made available to the markets through diligent research. Hedge fund managers told Oliver Wyman that companies are already freezing them out of their investor relations programs if they find they have a short position in their company stock. A subsidiary aim of the disclosure requirements is to prevent information asymmetries if other market participants are not adequately informed about the extent to which short selling is affecting prices. This extraordinary statement makes sense only if the authors believe that selling a stock does not disclose information to the market, or that those who guess correctly that a stock price will fall are in a morally inferior position to those who guess incorrectly that it will rise. True, short selling is a zero-sum game. The profits that accrue to short sellers are exactly equivalent to the losses incurred by those who buy and held the stock that is shorted. But unlike a career in European politics, where the salary of an MEP is taxed at 15% and the permissible expense allowances alone run up to 400,000 a year, short selling does entail risk. A short position has sometimes to be financed, not for days or weeks or even months, but for years. Even then, it might turn out to be wrong, and yield a ruinous loss instead of a massive profit. In fact, the losses on a short position are potentially unlimited: There is no cap on how high a share price can rise. Far from achieving the quixotic aim of preventing short sellers expropriating the wealth of shareholders who chose not to sell, disclosure requirements will expropriate the investment decisions of fund managers and make them available to everybody. There are already plenty of day traders trying to piece together from public information the investment strategies of Warren Buffett and John Paulson, and disclosure will equip them with a further source of data. The proposed European regulation can only enlarge their number, further increasing the mismatch between buyers and sellers.If a mismatch persists, a market is likely to become directional. Though the authors of the European regulation say they are concerned primarily to avert an excessive downward spiral in prices leading to a disorderly market and possible systemic risks, an absence of short sellers is just as likely to lead to an excessive upward spiral in prices. Short sellers put a floor on the decline of any market, because at some level the short sellers must cover their short positions. But they temper also the errors of optimism to which markets are prone. The investment bubbles now inflating in Brazil and China are in desperate need of short sellers to limit the eventual damage. Making it harder to short stocks in Europe is likely only to inflate them further, as allocations are diverted from European markets. Keeping asset price bubbles in check is not the principal role of short sellers, but it is one they are admirably designed to fulfill. They are contrarians by temperament. They are natural dissenters from the consensus. They ask the questions of corporate CEOs that journalists are too lazy to research and too easily corrupted to pose. It is short sellers that find the companies that are lying about their earnings, or the strength of their balance sheet. Enron and Tyco were being shorted long before journalists or regulators or lawyers discovered the management of the companies were not what they purported to be. Short sellers have as much interest in discovering and exposing corporate malfeasance as any investigative reporter, and more resources to pursue it with. They are allies even of the environmental movement and the labor campaigners, for a company that pollutes the landscape or mistreats its employees will see a fall in its share price. In the same way as they rescue investors from incompetent or corrupt management, they rescue voters from incompetent or corrupt governments. It was the hedge fund managers that shorted European currencies hard enough to release European economies from the bondage of the Exchange Rate Mechanism in 1992. In time, they will release them again from their enslavement by the euro. They will not be thanked for the trouble. Short sellers are, like ticket touts, deeply underappreciated servants of the public interest. There is a growing awareness in the industry of this potentially catastrophic failure of communication. The responses to the Global Custodian survey of securities lending published in this issue are replete with regretful allusions to the negative public image of the practice. The reputation of its twin sister, short selling, stands lower still. Short sellers have allowed people and interests other than their own to shape the public understanding of their character. As a result, they are synonymous not with performing a useful social function, but with excessive rewards, and speculative attacks on long-established currencies and companies. This is the handiwork of politicians and corporate CEOs eager to blot out their own errors of judgment. It is almost certainly futile to hope that the prime brokerage or securities lending or hedge fund industries will spawn an articulate and attractive defender of the practice of short selling. The few that raise their standard are apt to present their case in overly technical terms, and to believe that their opponents are open to persuasion rather than anxious to pin the blame on others. What short sellers need to do is follow the example of Carl Icahn, who transformed himself the corporate raider of the 1980s into the billionaire Robin Hood of the 21st Century. They need to break with the image their opponents have cast for them, and reveal their true nature as rebels and outsiders. They must cease to be people who make out like bandits when corporations and banks mismanage the wealth of others, and become what Eric Hobsbawm called social bandits. These are rebels treated by the establishment as outlaws, and even hounded as criminals, but which the people come to love as the champions of truth, avengers of those whose property is expropriated by others, and liberators of economies from the wealth-destroying projects of power-hungry politicians. In the eyes of the public, they need to become less like Fred Goodwin or Dick Fuld, and more like Marco Sciarra.