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Dismantling Wall Street’s excuses for short selling

Short selling benefits Wall Street – and just about no one else.

supply and demand for wall street mythbusters article

Short selling is a practice that Wall Street defends at every corner. For every one criticism of the practice, there are ten or more articles or ‘news’ stories that contend it has an important place in the market.

The resounding chorus of these oft-repeated defenses points to Wall Street’s need to control the narrative about short selling at large. In reality, short selling not only abuses the real economy, but puts an even higher degree of power and control in Wall Street’s hands.

So we’re going to address their main points to see what’s true and what’s myths that need to be busted.

But before we dive in, it’s important to understand that short sellers are not investors. They do not invest in companies. They have no shareholder rights, because they are not shareholders. They have no rights when it comes to a company and its stock price, least of rights that supercede the rights of real shareholders.

If they want to bet on the downfall of a company, they can place side bets offline that do not effect people’s livelihoods and the economy at large.

1: Short selling makes for efficient price discovery

TL;DR: Wall Street – not the market – decides what a company is worth, even if they don’t have a dollar invested

Those entrenched in Wall Street culture often argue that short selling helps to define efficient price discovery.

A Bloomber Businessweek magazine cover defending short sellers

This is objectively false. Short selling distorts the real value of a stock by its very nature.

Even when done properly – that is, not naked shorted – short selling adds artificial sell pressure to the market for which there is no counterweight on the buy side.

The price of a stock is supposed to be a function of supply and demand. If a company does well, more people want to buy its stock and are willing to pay more for it. Share price goes up.

Conversely, if a company performs poorly, shareholders could choose to sell their stock and might be willing to take a lower price for it, share price goes down.

These buy-and sell-dynamics on the share value are neutral in that it could go either way.

Unless a short seller steps in.

By only selling stock they never bought, but rather, borrowed, short sellers are effectively adding borrowed shares into circulation that were never bought nor issued by the company. As far as price discovery goes, it makes no difference is the share is borrowed or not. The sell pressure is still the same as if an investor who did buy the shares sold out of their position.

Say a company issues one million shares at $10 each, giving the company a market cap of $10 million. A short seller can come into the market and sell 500,000 shares they never bought. In effect, there are now 1.5 million shares in circulation.

But because the short seller never paid for the shares – only borrowed them – the market cap is still $10 million. However, now it’s divided over 1.5 million shares. Granted, the short seller will in theory have to buy back the borrowed share eventually. What the GameStop saga has revealed is that they often don’t even actual borrow the share. They simply “locate” it.

But until they do, they have dropped the share value over every investor from $10 a share to $6.66 a share.

Real shareholders lose money for no discernible reason, short seller profit from stealing that value, and…that’s it. That’s the long and short of it.

Importantly, there is no equivalent to the sell pressure short selling creates on the demand side. This imbalance alone highlights the distortion short selling creates. 

The counterweight demand-side force would be if anyone could remove stocks from circulation, adding the value of those removed shares into the company’s market cap. They would then have to keep a tally of how many shares they’ll eventually sell back into the market whenever they’re good and ready, if they ever decide they are. But no such practice exists – nor should it. It would just be too vulnerable to market manipulation.

In other words, short selling dilutes supply, but there is no market functional equivalent that has the inverse effect of concentrating the outstanding float. It is a one-directional force.

But for some reason, short selling gets a pass.

Company-initiated share buy backs have a similar net effect. But share buybacks are not a counterweight to short selling. Share buybacks are the demand-side equivalent of share shelf offerings – they can only be initiated by the company and must be announced in advance.

The financial media will say that short selling prevents company’s from becoming overvalued. Why should people with no actual investment in a company (because remember, short sellers are not investors) get to decide whether or not it’s overvalued? Shouldn’t those with skin in the game – actual shareholders – be able to decide that? How is that ‘efficient price discovery’? It’s not rocket science: If you don’t have money in the company, you should not be able to effect the investment of real investors. There’s no arguing it, there’s no debate. It’s a predatory scam.

If an investor –– someone who put money into a company in exchange for partial ownership rights –– thinks a company is overvalued, they have options. They can simply not invest in it or sell their holdings if they have some. Another investor might think that same company still has plenty of room to run and buy a holding based off the same numbers.

This is not efficiency. It is price distortion by its most fundamental nature.

Bad justification #2: Short sellers sniff out bad actors

TL;DR: They may sniff it out, but still have no vested interest in protecting real investors. A much more common scenario is that they are themselves, the bad actors. 

Unlike bad justification #1, there may be a tiny morsel of truth to this.

In theory, short sellers are incentivized to investigate companies. They may in the course of their investigation uncover fraud before investors do.

It makes sense in theory, but hardly ever plays out that way.

CNBC headline defending shortselling as an efficient price discovery tool

For one, even when short sellers acting in good faith legitimately uncover fraud in a company, they still have vested interest in the company’s failure. A negligible amount of short sellers have tried to correct the situation to protect other investors or the company’s employees.

Rather, they can simply let the situation play out or, do what they can to accelerate it. In fact, intervening ‘in good faith’ could backfire on a short seller. What if the company remedies the situation and recovers? Now the short seller is at risk of losing money. This is not their end goal.

Their investigations and due diligence may detect fraud, but detection doesn’t mean the situation will be corrected or even acted upon.

Contrarian investor Michael Burry of The Big Short detected something massive brewing in the housing market in 2005. The problem was, there wasn’t an established way take out a short position on subprime mortgages at large. Famously, Burry pitched the use of credit default swaps to effectively create the short position.

That required him to go bank to bank, explaining his thesis based on years of in-depth research on their own mortgage lending practices. Every major bank and several large hedge funds were informed of Burry’s findings three years in advance of the meltdown. How many of these banks intervened after being briefed on this short seller’s findings?

The rest is history.

Burry’s thesis would be proven unequivocally true. Still, in a 2010 op-ed for the New York Times, Burry reflected:

Since then, I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions.

As it turns out, uncovering fraud or poor business practices doesn’t mean anyone who can do anything about it will listen. Not even in retrospect!

Additionally, there comes a time that we have to evaluate our assumptions against the backdrop of history.

On the contrary, there is a much more extensive history of short sellers being the bad actors themselves, taking proactively malicious positions agains a company. With vested interest in driving down the price of a company’s stock, short sellers becomes the bad actors themselves.

Indeed, there are many more cases of short sellers proactively sabotaging companies with manipulative media tactics, bad analyst ratings, saddling struggling companies with frivolous lawsuits, and preventing them from raising capital all in hopes of driving the price of the stock down or better still, drive the company into bankruptcy, in which case they get to keep all the money from selling the stocks they never bought, tax free.

Bad justification #3: Short sellers are part of a free market

TL;DR: Short sellers and the framework needed enable it effectively empower Wall Street to crush competition of their other vested interests and stifle innovation. 

Make no mistake: Short sellers are the enemy of a free market. The practice gives those with deeper pockets the tools and levers they need to exert control across the entire real economy.

This excuse might be the most heinous of them all. It exemplifies Orwellian levels of double think that only Wall Street could package and sell. It’s reminiscent of a child throwing sand in another child’s face on the playground, then citing freedom as their reason for doing it.

As covered in bad justification #1, short selling is a force of price distortion. Period.

Similarly, the legal practice short selling has a long and ugly record of producing bad actors exactly because it empowers them with the ability to manipulate the price. The more money they have, the more power they have over price movements.

As such, there’s extensive reason to believe that short selling is used to snuff out innovation, put premature death sentences on struggling American companies with potential for turnaround, and crush competition of short sellers’ other financial interests.

Free market innovation interrupted: Viragen

GameStop-anchored subreddit r/Superstonk members began researching and posting documents from bygone years from companies that had filed complaints with the SEC about short sellers.

One company that caught special attention from the forum was biotech company Viragen. Viragen was among the first to research and develop immunology treatments.

Their trials showed tremendous promise in the late 1990s and early 2000s. In fact, looking at press releases at the time, one might have thought that the company was on the up and up. It gained patents, had promising clinical trials for a cancer treatment, and successfully genetically modified chickens to lay eggs with cancer-fighting drugs to reduce the cost of production, a process that had obvious commercial implications. The company had even done a substantial amount of research on coronaviruses during the 2003 SARS outbreak – research that would have come quite handy seventeen years later.

Yet, despite its many wins and promise, Viragen still fell into the cross hairs of short sellers. The company’s CEO, Gerald Smith, filed complaints with the SEC about abusive short selling. Motley Fool, a usual suspect in Wall Street media smear campaigns and megaphone for hedge fund pump-and-dump schemes, named the promising biotech company one of the 10 worst performing of the decade.

As Viragen’s share value continued to decline, the company was caught in expensive litigation. Despite promising clinical trials on some of its products – and even an approval by Sweden’s FDA analog for its drug Multiferon – the company ran out of money. It wasn’t able to raise capital against diluted share price.

With so many promising drugs in the works and several active patents, the bear thesis for Viragen – which ultimately won the day – is hard to understand.

The company was liquidated in 2007.

Redditor u/phoenixfenix created a thread entitled Naked Short Sellers have set our cancer research back decades from their abusive short selling a post that garnered over 20,000 upvotes.

Biotech is a competitive and expensive industry with large upfront investment requirements. Sometimes their research fails to bring their product to market, and they go under.

That might have been Viragen’s fate. If Viragen’s investors had been disappointed with the company’s progress and wanted out, Viragen’s story would be one of failure in a free market. Instead, Viragen’s real investors were forced to watch their investment bleed, despite positive developments. All thanks to Wall Street insiders with deep pockets and not a single dollar invested in the company exerting their influence.

The company’s value was siphoned out by short sellers. The executive team was forced to invest time and resources defending the company from false bad press (surely, shill post Motley Fool was on the bullhorn) from a bear thesis that was both unclear and objectively false.

In one particularly egregious example, an article was published that stated the company’s CEO, ‘Michael Grosbest,’ had sold his stock. The company’s real CEO, Gerald Smith, had not sold stock. Michael Grosbest was an entirely made up name – no such person worked at the company at any point. It begs the question: Why would anyone write a story that is objectively false on multiple fronts?

Viragen was so ahead of its time, the field it was creating with its research – immuno oncology –hadn’t even been named yet.

Today, the field Viragen laid important groundwork for is projected to hit $250 billion in pharmaceutical sales by 2024 – of which the pioneers of the field don’t get a crumb.

In a 2003 complaint to the SEC, Dr. Jim DeCosta, consultant to corporations victimized by short sellers griped:

The sobering reality is that it usually doesn’t matter if the development stage company “has the goods” or not. Even if that new technology or cancer cure is legitimate, the company can’t out muscle Wall Street.

That leads us back to the same question: Why should people who never put a dollar into a company be allowed to decide its worth? Whether it should even keep operating? What’s to stop bigger industry players from throttling out competition and therefore innovation? Additionally, why should anyone other than the issuing company get to decide how many shares are in circulation?

Speaking of ‘free markets’: In an act of eye-watering hypocrisy, when Wall Street’s own fraud and poor business practices exploded the fall of 2008, the SEC banned short selling of financial stocks only. Other companies were left to the piranhas, but big banks were protected from their own predatory and abusive practices, the ones they often argue is a beneficial force in the markets. After all, there was a lot of money to be made on shorting a collapsing economy.

This is Wall Street’s idea of a ‘free market.’

Bad justification #4: Short selling provides liquidity

TL;DR: The additional liquidity enabled by short selling can also be used to control price formation. It’s liquidity that only benefits Wall Street – not the market. 

Liquidity! Liquidity! Dear God, someone please think of the LIQUIDITY!

Not five minutes goes by on CNBC without a Wall Street suit and their cronies talking about the holy sacrament that is market liquidity.

Liquidity is by far the most overrated word on Wall Street and in the financial press. Liquidity in the context of short selling is also a shameless contradiction of efficient price discovery (a soundbite Wall Street believes makes them sound very smart and important) and that ‘short sellers have a place in a free market’ arguments.

Let’s examine how the liquidity argument contradicts both earlier points.

Efficient price discovery: To beat a dead horse, price discovery is supposed to be a function of supply and demand.

If buyers and sellers do not agree on a price for a share, there will be low liquidity. But odds are, if they’re both at the point of wanting to buy and sell, they will come to an agreement. Either the buyer will agree to pay more, or the seller agrees to less. The price moves. Someone budges. This is the very mechanism of price discovery.

For a third party to step in an “provide liquidity” by subsidizing the market with shares is a blocker of real price discovery. The “additional liquidity” created by putting IOU supply into circulation is now an X in an equation, and how much the ‘unknown’ X is effecting the price. The more IOUs in circulation, the bigger that x factor becomes.

The seller who has actually invested their dollars is of course hurt the most by this artificial liquidity. It bears repeating: Short sellers are not investors. That is the antithesis of a ‘free market,’ no matter how many times “pundits” parrot it in Wall Street Journal or on CNBC.

The most absurd part about this argument/excuse is that in reality, they’re ‘providing liquidity’ – for short selling. Many stocks are still highly illiquid. That’s the risk investors take when they buy certain stocks, particularly penny stocks or unknown small and mid-cap stocks. This ‘additional liquidity’ they shout from mountaintops does not mean that short sellers or stock lenders will buy shares off of real investors in the event of illiquidity in the form of no one will buy from them. It is one-way liquidity.

What they really mean is that short selling allows more liquidity for themselves, which is in turn leveraged to manipulate the “free market.”

What is not said about short selling

Wall Street and the financial media are unsurprisingly mum about the real consequences short selling has on Main Street and the real economy.

Short seller profits are Main Street’s loss.

When short sellers extract their profit from company market caps, it bleeds out Main Street’s 401ks and pensions, which are generally held as long positions.

When company’s market valuations are eroded, they often have to cut costs. Layoffs are a common byproduct of significant stock value drops.

When hedge funds have vested interest in swaying sentiment one way or another, Main Street is lied to by the media sources cleverly disguised as ‘news sources.’

There have been hundreds, if not thousands of complaints filed with the SEC about abusive short selling. The SEC generally plays dumb, launches investigations that really serve Wall Street’s interests more than anything, and plays babe in the woods as companies being bled begging for help. This has been going on for years.

Articles get published using the above justifications verbatim over and over. These articles never contain concrete, real world examples of short selling having a net positive impact on Main Street. That’s because there aren’t any. Juist like short selling itself is an asymmetric market force to the downside, unless you are short selling yourself, it is always working against you. Always: 100% of the time.

So they do what they always do: Appeal to ‘academic’ language and abstracts to make it sound like when they “sell” property they never bought with. no real intention of buying it back, they are doing something very smart and important that “unsophisticated” people don’t understand.

The relentless ‘short selling is beneficial’ narrative push by the financial media is reason for pause. After all, Wall Street has vested interest in protecting their power and advantages. The existence of short selling at large enables market manipulation of stock prices by large players with no actual investment in the company’s they make it their business to destroy for profit or in some cases, to snuff out competition.

With a system so shamelessly rigged in their favor and the market firmly pinned under their thumbs, they have little vested interest in telling the truth.

Notice that the common denominator of all of these new fraud investigations is the Wall Street “professional” taking advantage of his superior knowledge of, access to, and visibility of the markets while picking the pockets of mom and pop investors.The common theme holds true. It’s the Wall Street “professionals” against the mom and pop investors. –Dr. DeCosta

Sadly, DeCosta’s wise words fell on deaf ears 20 years ago, just as they do today with GameStop Investors, as they did with Viragen, and as they will with future companies that fall prey into the crosshairs of wealthy institutional investors.

Author

  • Jack Tazman is a Baltimore, Maryland native. He attended Washington University where he studied political science. Since then, he worked as a writer for various national news organizations specializing in politics and policy. He now resides in New York City as a freelance writer and political consultant.

2 Comments

  1. You are 100% right about all this and hit on the key points that most people ignore(but which one can prove using simple math).

    To expand on the issue about fluffing out fraud: It’s worse than what most people think because shorters claim that they are helping “investors” by fighting fraudulent companies. But what they do is actually is steal from investors.

    Suppose that you have fraudulent company and suppose some long investors have bought in thinking it was legit. It happens, it happens a lot(some of the biggest companies started off as fraudulent and somewhat still are).

    But shorters come in thinking they can “expose” it… and they start shorting. Start publishing FUD(either legit or not) and all that and the company takes a nose dive. The shorters then profit.

    But who do they profit from? 1. They profit from the original investors who are stuck holding the bag. 2. They profit from any new long investors that get swindled(as there has to be a seller for shorters to cover).

    So they are actually stealing from the investors who got swindled by the company. Ok, fine, the longs should have done more DD. BUT for the shorts to claim they are better than the fraudulent company is moronic. All they did was use the fraud company(which many shorters create intentionally do carry out their scheme) as a proxy.

    Without shorting, fraudulent companies would end up with some stock price from which all/most potential investors know the company is fraudulent and so there is no demand… and hence the sellers cannot unload their stock. This is how it is suppose to work.

    If shorters really were about helping they wouldn’t short but just expose fraudulent companies by using real information. In fact, the shorters are just criminals but we already knew that.

  2. The second point is that with shorting there is a huge incentive to manipulate. Either create fake companies(shorters create them, know they are fake, hype them up and get investors to fall for it then come out later to “save the investors”) OR try to bankrupt the company or hurt it in some way to make sure the shorting pays off(of course with a healthy dose of puts at the top and calls just before covering).

    Shorting is the legal means to cheat. Also, even without naked shorting it still has the effect. Naked shorting is just outright theft. It’s not shorting, it’s counterfeiting. Non-naked shorting still is asymmetric downside pressure as pointed out and creates artificial supply in the sense that sellers who are not selling but having their shares “borrowed” are having their shares sold(so there is more selling than would be and hence the price decreases).

    You can’t have any forms of shorting or options in a free and fair market. All these are just schemes criminals/sociopaths created to steal from investors. They complexity the schemes to make them seem legit, push a lot of disinformation so they can get away with it. There is a reason why things are the way they are. When you reward sociopaths in society expect that society to go insane. The fraud market rewards sociopaths and now it is so bad it threatens the very survival of the human race as we know it and potentially more because it is likely to lead to WW3 and nuclear annihilation. The reason is simple: Once the sociopaths are in large enough numbers how can they be stopped? They have taken over so many positions of power such as regulators, politicians, generals, bankers, etc and since they are, by their nature, emotionally disconnected from the suffering of other humans and ignorant of the consequences of their own actions they will keep pushing the envelope for more and more.

    What generally happens, and this is true beyond short selling(but it is all connected to sociopathic disorders), is that as they do their damage to society eventually society cannot keep up with the barrage of attacks by the sociopaths and starts to succumb. As it does the sociopaths end up becoming even more insane as they ramp up their parasitic attacks on society. At first it is because they are able to become more rewarded but eventually they become less rewarded and so much work even harder to maintain(or improve) their rewarded conditioning.

    This is why it is very much like an addict. At first when they try the drug for the first time their body and mind is strong and the drug is very rewarding. This reward then is sought out more. But as they continue using the drug, at first the euphoria intensifies as the body and mind becomes more accustom to it. Over time though the drug does alters the body and mind and the damage accumulates to such a point that it becomes a negative. The addict seeks out the same or more intense euphoric effect but cannot get it or it requires larger and larger quantities. At some point though the diminishing returns is cannot be sustained.

    Money is a drug, has the same types of mental effects on a person. A euphoric effect(shorters seek the instant gratification kick as they hit the short button and instantly see “free money” show up in their account) but over time as they short and short and short margin comes(or infinite risk). Some are lucky and survive it and walk way, others actually get away with it(usually at the cost of doing more crime.

    Regardless, shorting is insane and criminal and provably has a detrimental effect on price discovery and investing and ultimately on society(as the problems it creates trickle out from the stock market in to the economy and then in to societies behaviors). Shorters generally are not emotional stable nor intellectually wise. When they get their $$$ where does it go? Does it go in to making humanity more stable and safe(after all, they just stole from countless investors) or does it go in to materialist things or things that further the destruction of society?

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