Selling Stocks Short: Ever Controversial

Selling securities short has been a controversial practice as long as financial markets have existed, and the recent financial crisis brought short selling to the fore yet again. In the last week, a bill to impose new restrictions on short selling was introduced.

And earlier this month in its inaugural conference, the Atlanta Fed’s new Center for Financial Innovation and Stability (CenFIS) provided a forum for discussing the topic of short selling.

Why does short selling have such a bad reputation? Financial economists generally have a positive view of short selling because short sellers take positions with risk of loss based on their view of a firm’s prospects. Some others, though, generally do not take such a benign view of short selling.

Attitudes toward short selling reflect views about speculation. As Stuart Banner notes, a common historical view was that “[s]peculation was both productive and wasteful; it satisfied an evident demand, but its practitioners added no value to the community” (Banner 1998, p. 23). Banning short selling also has a long history. In the United Kingdom, “An act to prevent the infamous practice of stock-jobbing” was passed in 1734, an effort that attempted to ban short selling and was not repealed until 1860. In the United States, contracts to sell stock not owned at the time of sale were unenforceable in New York courts from 1792 to 1858.

Possibly short selling has a bad reputation partly because of its association with “bear raids.” A bear raid is a set of trades in which a stock is sold short at a high price, negative rumors are spread to cause the price to fall, and then the short sales are covered by purchasing the stock at the lower price. Some discussions of bear raids suggest that buying stock on the way back up is a way of adding to the raider’s profits from manipulating the stock price.

Bear raids are similar to speculators’ manipulation of foreign exchange (Friedman 1953). Both are based on attempts to move a financial market price independent of any underlying development. Successful instances of bear raids and exchange-rate manipulation are similar in another way: They are far less frequent than complaints about them.

Selling securities short has a long and controversial history. While it’s not clear whether proposed legislation on short selling will be enacted, it’s a good bet that short selling’s risks and benefits will be debated for quite some time.

References

•Banner, Stuart. 1998. Anglo-American Securities Regulation. Cambridge: Cambridge University Press.
•Friedman, Milton. 1953. “The Case for Flexible Exchange Rates.” In Essays in Positive Economics, pp. 157-203. Chicago: University of Chicago Press.

About Gerald P. Dwyer 2 Articles

Affiliation: Federal Reserve Bank of Atlanta

Gerald P. Dwyer is Director of the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta and an adjunct professor at the University of Carlos III in Madrid. At the Federal Reserve Bank of Atlanta, he is in charge of the finance group in the Research Department.

Since receiving his Ph.D. at the University of Chicago, he has been a faculty member at Texas A&M University, Emory University, the University of Houston and Clemson University. Dr. Dwyer also has been associated with the Federal Reserve Banks of St. Louis and Chicago.

Dr. Dwyer's research has been published in leading economics and finance journals. His research also has appeared in the Reviews published by the Federal Reserve Banks of Atlanta and St. Louis as well as in books and conference volumes. He is on the editorial boards of the Journal of Financial Stability and Economic Inquiry. He is president of the Association for Private Enterprise Education and a past president of the Society for Nonlinear Dynamics and Econometrics. His research interests are in banking and financial markets.

Visit: Gerald Dwyer's Page

1 Comment on Selling Stocks Short: Ever Controversial

  1. This is probably why the movie “Stock Shock-The Short Selling of the American Dream” was made–as so many investors in Sirius XM blamed short selling for the stock declining to 5 cents/share. Stock Shock definitely makes the whole concept of naked shorting, and market manipulation easier to understand. Amazon sells the DVd

Leave a Reply

Your email address will not be published.


*