In defense of the misunderstood short seller

It is a tough time to be a short seller. 

The business model of these unpopular market actors is constantly under attack; by regulators, CEOs and, most recently, by the new online generation of retail investors. Yet it’s important to note that short sellers, though they’re frequently despised, are often misunderstood. They play an important role in stabilizing and policing financial markets, keeping prices honest and reducing volatility and transaction costs for all. Instead of hating them, we should be thanking them for their service. 

Low rates, government stimulus and now an army of retail investors have driven the stock market to new highs adding billions to the market caps of nostalgic and previously unloved companies, including GameStop, Nokia and Blackberry.

Market behavior has proven entirely unpredictable, at times seemingly separated from fundamentals. For example, an attempted short squeeze made GameStop, a consistently unprofitable brick and mortar retailer, one of the most expensive companies in the world to short; more than 100 times more expensive than Tesla. The unprecedented GameStop rally, driven by a legion of retail investors and some hedge funds, cost short sellers as much as $13 billion.

But the abuse short sellers face hasn’t just come at the expense of their balance sheets. Short sellers have faced everything, from harmless jokes like Elon Musk’s “$69.420 short shorts”, fake tinder accounts and unexpected pizza, to more malicious behavior in the form of death threats, harassment and targeted hacks; the latter pushed an infamous short seller to shift its business model entirely away from shorting stocks.

Short sellers are an unpopular group, making them an easy target for regulators and policy makers. Following the GameStop fiasco, Rep. Maxine Waters (D-Calif.) went so far as to place the blame for market turmoil firmly on short sellers, announcing that “predatory short selling to the detriment of other investors must be stopped.” Water’s sentiment is not unique; policymakers frequently blame short sellers during crises. Bans or restrictions on short selling have been enacted at some point in most major economies, with policymakers claiming that short selling exacerbates volatility and threatens market stability.

But the blame is entirely misguided. Short sellers play a critical role in supporting market functioning. From policing markets and warning investors about potential fraud, to supporting the price discovery process by carefully scrutinizing the financial statements and valuations of companies, short sellers play a highly visible role in keeping prices honest. As a result, rather than contributing to volatility, short sellers help to stabilize markets.

In fact, restrictions on short selling by policy makers consistently lead to intensified market volatility, reduced liquidity and increased trading costs, hampering investors’ ability to price assets in periods of high uncertainty.

Bans on short sales would be catastrophic to investors.

For more than a decade leading up to a ban on short sales of Wirecard stock by German regulators, the company had been the target of countless short seller research reports exposing allegations of fraud and dishonest business practices. Wirecard, often with the support of regulators, aggressively pursued these claims, burning activist investors and hedge funds in the process as its stock price continued to rally. At one point, Wirecard was even in talks to acquire Deutsche Bank, boasting a market cap equivalent to that of the $1.4 trillion bank. Ultimately, the deal never materialized. That was due in large part to the uncovering by auditors of $2.2 billion in missing cash and systematic fraud conducted by Wirecard executives. The proposed deal was likely an attempted cover-up, with Wirecard leaders hoping to handwave the missing cash in the post-merger impairment charges. Ultimately, Wirecard’s investors, including several large pension funds, lost billions as the company became insolvent.

Wirecard is not the only example of short sellers sniffing out fraud far ahead of regulators, auditors and the public. In fact, in one study by researchers at HEC business school, as many as 50 percent of the companies targeted by the sample of short sellers were delisted, suspended or subsequently went bankrupt.

From spotting hundreds of millions of dollars in falsified sales data, to revealing large scale fraud by Chinese companies targeted at American investors, short sellers have a respectable track record, proving that every once in a while the market benefits from a little skepticism.

Ultimately, the business model of short sellers is dependent on credibility. Without providing compelling evidence and rhetoric, the research reports and disclosures of short sellers would carry little weight. For this reason, high interest by short sellers is frequently a sign that something is amiss.

Short selling is reflexively unappealing and unsexy. However, we should not lose sight of the benefits that come with adding profit potential to scrutiny and skepticism. And in the case of GameStop, we shouldn’t blame short sellers for being on the wrong side of a bad bet. They were left holding the bag on an unprecedented loss that resulted in the transfer of billions to many (inexperienced) retail investors. Instead, we should show our appreciation to the misunderstood short seller who, despite the relentless hate and scrutiny, continues to weather the storm in hopes of finding a pot of gold under yet another fraudulent rainbow.  

Hugo Dante is a Young Voices associate contributor and a Washington-based banking policy analyst. Follow him on Twitter @hugodantejr