Volatile trading of regional bank stocks following First Republic Bank's collapse has stoked fears of possible market manipulation and intensified scrutiny of short-selling activity as a potential cause of the instability. Short selling is an advanced trading strategy that profits from a decline in a security's price. Short sellers sell borrowed shares that they believe will fall in value in hopes of buying them back at a lower price to repay the loan. Since the loan is based on the number of shares and not the dollar amount of the position, the spread between the sale and purchase prices of the underlying security constitutes the profit or loss of the trade.
As short interest grows in any particular stock, price swings can become more pronounced as long and short traders jockey for position. The use of direct leverage and leveraged financial instruments can further exacerbate price movements in either direction.
The recent extreme whipsawing seen in regional banking stocks has led to calls for the Biden administration to institute a short-selling ban in order to stabilize markets and protect retail investors. This is not a new idea; short-selling bans have been enacted in the past, most notably in 2008 during the Great Financial Crisis when the SEC under the Bush administration issued a temporary stop on short sales of 799 financial stocks.
White House officials demurred when asked recently about the possibility of a ban, ruling out any imminent action while preserving future flexibility to intervene if current SEC investigations yield evidence of trading improprieties. The public should recognize this sudden scrutiny of short sellers as nothing more than a red herring on the part of government officials. Regional bank stocks correctly reflect the fluid and extremely uncertain nature of the banking crisis. The destruction in shareholder value has very little to do with traders illegally coordinating or spreading false information and everything to do with a collective societal realization that banks have a flawed and vulnerable business model.
In truth, short sellers are an important part of the financial world. They provide valuable information that informs price discovery in a market that is not perfectly efficient. They also serve as a check against wholesale fraud and corporate malfeasance. As an example, a short seller named Hindenburg Research played a critical role in exposing EV startup Nikola Motors as an elaborate con with no viable products. Evidence came to light that confirmed Hindenburg's suspicions, leading to the destruction of the startup's $34B market capitalization and the eventual conviction of the founder for his role in the deception.
In nature, a group of organisms called decomposers feed on dead and decaying material, nourishing themselves while making vital nutrients available to the ecosystem in the process. Their presence is critical in maintaining the fragile equilibrium of the environment. Short sellers play a similar role in financial markets, profiting from the proper identification of distressed companies while accelerating the process that returns unproductive assets and capital back to the system for reuse and new investment.
Bad ideas and poorly managed businesses should be allowed to fail in a free market. Failure creates space and paves the way for new ideas and better-managed competitors to succeed in a process known as creative destruction. As long as short sellers follow the law, investors should embrace them as vital contributors to the long-term health of financial markets, not the destabilizing boogeymen the media and government portray them to be.