Markets

Addressing Mistrust of Short Selling

When it comes to short sellers, people either love ’em or hate ’em. Never popular, short sellers seem to evoke a visceral animosity from a vocal segment of the investing public. We saw that earlier this year in the meme stock short squeezes that reportedly pitted Redditors and Robinhood traders against short selling hedge funds. In the words of my son (a non-combatant in the struggle), the object of the retail investor warriors was both to make money and “stick it to the man.”

For all their unpopularity, though, short sellers remain popular in one small corner of the world: the view of economists and capital market experts. They see short selling as benefiting markets and investors by identifying overvalued stocks and cases of outright fraud. If you have a passively invested pension fund or ETF that must hold an index, you should welcome short sellers that help keep the prices of stocks in the index sustainably aligned with their intrinsic value. From a market perspective, short selling enhances price discovery, guards against asset bubbles, uncovers fraud, provides liquidity, facilitates capital formation, and makes capital allocation more efficient. 

Those economic arguments notwithstanding, however, the meme stock trading frenzy focused popular resentments and suspicions on short sellers. The U.S. House Financial Services Committee launched a series of hearings under the rubric, “Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide.” And regulators began considering ways to beef up the rules on disclosing short interest.

Regulatory fairness, however, is in the eye of the beholder. Take, for instance, the requirement for large institutional investors (managing at least $100 million in certain equity assets) to report their holdings every quarter on Form 13F. The reports cover equity securities traded on an exchange, options, and certain other securities—but not short positions. Shorts are conspicuously absent from the disclosure requirement. That’s unfair, say critics. Not really, SEC economists have said in the past. In a 2014 report on short sale disclosures, the SEC’s economic unit commented, “The Division does not believe that asymmetry in reporting requirements is problematic per se if the concerns addressed by the disclosures are similarly asymmetric.” 

But the SEC appears to be revisiting the issue. It has put 13f disclosures back on its rulemaking agenda, and Chairman Gary Gensler told Congress at one of the “Game Stopped?” hearings that he has asked for staff recommendations. 

Meanwhile, FINRA, which regulates broker-dealers, has proposed a menu of rule changes to increase the content and frequency of reporting of short sale interest. FINRA already requires broker-dealers to report aggregate short interest information for equity securities, and it is considering requiring further breakdowns of the data, such as separate categories for the short interest of broker-dealers and their customers. 

Here the other side can complain of regulatory asymmetry. Since long investors face no comparable requirements, critics maintain, it would be unfair to mandate them for short sellers. Why is FINRA proposing this, and why now? Surely the meme stock/short sale frenzy catapulted this to the top of the agenda. But as counterintuitive as it may sound, short selling hedge funds arguably were the victims of social media-inspired short squeezes that, if conducted by institutional investors, would have been considered market manipulation. So why single out the victims for more regulation?

Though there is some merit in the critics’ arguments, in my view the proposals’ pros outweigh the cons. For instance, categorizing broker-dealer and customer aggregate short interest would add to the total mix of information for investors. It would give a better sense of negative market sentiment (albeit imperfect), because broker-dealers typically sell short for hedging purposes, while a segment of their customers sell short because they believe a stock is overvalued. Information on directional short sales—based on the expectation that the stock price will fall—is valuable. As the 2014 SEC study observed, “Empirical studies also support the idea that short sellers are informed, suggesting that information about short selling could help investors better value stocks.”

FINRA is also considering requiring disclosures of synthetic short positions, in which investors use derivatives, futures or options to gain economically equivalent exposure to selling a stock short. If broker-dealer reporting of synthetic short positions proves feasible, it would give investors a more complete picture of negative market sentiment.

Investors and markets also would benefit from FINRA’s proposal to increase the frequency of short interest reporting from twice-monthly to weekly or daily. Some private firms already collect and sell this information on a daily basis, but at prices out of reach for many individual investors. Regulatory reforms would level the playing field.

Or would tighter regulations backfire? Would they expose the strategies of short sellers, make them vulnerable to anticipatory trades or short squeezes, and have a chilling effect on their activities? That seems unlikely, given the availability of similar or even more detailed data from private vendors today. Moreover, we’re talking about aggregate short interest data, not individual positions. (FINRA also proposes to collect account-specific short position data, but only on a confidential, non-public basis for its work in policing markets.)

Finally, unsustainably high levels of investor mistrust demand our attention. Just look at the record response rate of more than 1,800 comment letters on the FINRA proposal itself. Many come from individuals expressing mistrust of hedge funds and short sellers and perceptions of market manipulation, captured regulators, and rigged markets. If enhanced transparency can help to dispel or reduce the mistrust, the proposals will be worth adopting.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Market Regulation

Stephen Deane

Stephen Deane, CFA, is Senior Director, Legislative and Regulatory Outreach, at CFA Institute.

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