Building A Stock Market Is Hard

When CNBC host Melissa Lee uttered the words “naked shorts,” you could almost hear it reverberate through the entirety of Wall Street. (In fact, this YouTube video played with this theme.) She spoke the unspeakable! Melissa Lee herself seemed surprised. She had a look on her face, which was captured by the cameras, which seemed a combination of “What just happened?” and “Can they fire me over this?” 

Melissa’s job seems safe and it should be. We as a society will be much much better off if we can have an open conversation on shorting.

So what’s the issue here? Without going into too much detail, the issue is regarding a specific way of shorting. Remember, shorting is the practice of borrowing a share that you don’t own and selling it with the objective of covering it (buying it back) at a lower price and pocketing the profit. Dubbed by many as an unethical practice, it is actually simply the opposite of buying low and selling high. As Khan Academy explained here, it is a much-needed balancing mechanism because there are so many people whose incentives are aligned with an increasing stock price. For the markets to be balanced and fair, traders should be given the opportunity to take the other side of the trade. The ability to sell what you have is not enough. If you have no position in a stock and if you think it will go down, you should be able to enter into a trade to take that position. 

To be fair, shorting still faces some obstacles. For one, your average stock market goes up more than it goes down (at least that’s what has been happening in the U.S.), so shorts already start the race a step behind. Shorting also has unlimited downside because the stock price can theoretically increase to any level, making it risky. Thus, it is really hard to label shorting as investing; there is generally not enough margin of safety. In addition, in order to short a stock, you first need to locate a share that you can borrow, and that is not always easy. Despite these obstacles, if there was no shorting at all, the stock market would lose contrarian voices, which can be extremely helpful in identifying fraud, which is exactly what happened with Enron many years ago. The following passage is illuminating:

“Of short sellers such as Mr. Chanos, an Enron spokeswoman says: "It was in their financial interest to drive the stock price down, and they raised whatever doubts and whatever issues they could to further their own financial gain."

But the exact same thing can be said for the long side! It takes two to tango. Some people have a financial interest to drive the stock price up and some people have a financial interest to drive the stock price down. The markets are where these opposing views come to light and result (at least theoretically) in an efficient, fair market. 

Enron, of course, would declare bankruptcy about a month later after its spokesperson took a dismissive view of the short sellers. Enron ended up going down, taking the public accounting firm Arthur Andersen (their auditors) with it. If you feel like reading a book about this, this one is very good: The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. This scandal ended up leading to tighter rules and accounting standards which are now widely known as Sarbanes-Oxley. 

Is shorting bad? No, not when it is done within the rules. It helps the markets become more efficient. Enron did not fail because it was being shorted. It was already failing, we just didn’t know about it. Some people paid attention, saw what was wrong with the company and decided to put their money where their mouth is; this is exactly how markets should work. 

Shorters get a lot of heat sometimes. Again, recall that there are many people who want the stock price to go up and not a lot of people who want it to go down. However, we need both sides to have a voice if we care about fairness. An entire book is written on this, titled: Don’t Blame the Shorts: Why Short Sellers Are Always Blamed for Market Crashes and How History Is Repeating Itself.

Going back to the CNBC segment, naked shorting is when you sell stock that you haven’t borrowed yet, or located for the purposes of borrowing. Basically, you sell the stock without having shown that you already have or will have it. The problem: Naked shorting is illegal, at least in the U.S. Whether this is a practice that should be banned or not can be debated, but the law is the law. Until and unless it changes, it needs to be respected and enforced. 

So why do we not see much enforcement in this space? Consider this recent discussion.

Again, Melissa Lee’s surprise on live TV seems to have triggered a conversation and that’s a good thing. 

Building a stock market is hard. Very hard. How do we create balanced markets? How do we make sure that everybody has a voice? How do we make it fair? What is fair? Should shorting be allowed? If so, what is the exact mechanism for shorting? 

When we were building AllSportsMarket (ASM), these types of questions would come up on a daily basis. Traders would provide us with valuable input and naturally, there were disagreements as well. It is hard sometimes to separate what is good for you from what is good for society in general. 

Then there are unintended consequences. The designer implements something with the best of intentions only to find out that it created a perverse incentive for someone, somewhere; like shorting. It theoretically does lead to a balanced market, but what if one starts disseminating false information, shorts the stock, pockets the gains and disappears. 

The problem, in this case, is not in shorting stock, it is with disseminating fake news. Unfortunately, by the time the facts are sorted out, if ever, the damage would likely have already been done. What rules should we implement to incentivize good shorting and disincentivize bad shorting?

In these moments of confusion, going back to the principles tends to be a great idea. We must remember that shorting, at the end of the day, is just a mechanism intended to create fair markets. The end game is not about the exact mechanics of shorting, but fairness, truth, transparency and inclusiveness. If we design markets with those fundamental principles in mind, create the laws around them and enforce them, we will be in a good place. We may still not get it perfect, but we will likely end up pretty close to what was intended.