Since the first company stock was sold in the 1600s, short sellers have been blamed for the worst moments in the world's financial markets. This trading strategy, its proponents say, provides greater liquidity to the market, tempers excessive hype around trending assets, and helps prevent market bubbles. The public and its representatives frequently paint a far less rosy picture, depicting short sellers as vultures sweeping in to profit off the misery of others. Company executives have accused them of driving down their company's stock prices. Some governments have banned the practice, while others have halted short selling to give their markets time to regroup after crises. We have seen this tension play out consistently since the practice began. Read on for a history of short selling through the attempts to ban or curtail the practice.
Key Takeaways
- Short selling is a trading strategy in which an investor bets that a stock's price will decline. It exists in markets worldwide.
- Short selling securities has been in use since stock markets began on bridges in the Dutch Republic in the 1600s. Shorting of the Dutch East India Company led to thefirst ban of the practice.
- In the 18th Century, Great Britain banned naked short selling, which occurs when the shares shorted aren't borrowed first by the short seller. In France, Napoleon Bonaparte outlawed short selling in 1801 as an affront to the French nation.
- In the U.S., short selling was first barred during the War of 1812, restricted during the Great Depression, and since then has been under greater scrutiny, especially after market turmoil in 1987, 2001, and 2007-8.
- Today, short selling is legal in most jurisdictions, with economists arguing it increases market efficiency and liquidity.
Short selling isn't new; it's been around ever since the origin of the stock market. Indeed, shorting predates these markets as grains and other commodities were commonly shorted beforehand. However, the sellers' pessimism that goes along with these trades hasn't always been welcome. While others root for a stock price to go up, short sellers make money only if it declines. To do so, they borrow the stock from a broker, sell it, and wait for the prices to drop so they can buy it back at a cheaper price.
Early Short Selling Regulations
The Dutch Republic
Short selling has been around since the stock market emerged in the Dutch Republic during the 1600s. In 1609, Isaac Le Maire, a prominent merchant and former board member of the Dutch East India Company (or VOC, the acronym from the original Dutch name), sought revenge after the company forced him out and he was banned from the lucrative spice trade. Le Maire held a significant amount of the company's stock. Along with some confederates, he sold short the company's shares in great quantities to drive the price down, attempting to ensure the price fell by spreading rumors about ships that had sunk, cargo being lost at sea, and so on. The Dutch government soon took action and instituted a ban on short-selling.
Le Maire shows the perils of such gambits: his VOC shares were seized and he soon fled into exile. After he later died in a humble seaside village, a tombstone was placed at his grave, saying that he had won and lost a great fortune, but not his honor.
Many governments have limited or forbidden short selling because of its use during stock market sell-offs and financial crises. However, outright bans have usually been repealed, as short selling is a significant part of daily market trading.
Great Britain and the South Sea Bubble of 1720
Naked short selling was first outlawed in 1733 as part of the fallout from the South Sea bubble of 1720, one of the first major crises to hit modern financial markets. The difference between naked short selling and a regular short sale is that the shares being shorted are never actually borrowed or secured for lending to the short seller. As such, if the short seller goes bankrupt or can't locate the shorted security when it's time to pay back the stock lent, a failure to deliver is far more likely. This is much like writing a paper check for a checking account that doesn't yet have the funds for the check to clear.
The South Sea bubble of 1720 centered around the South Sea Company, formed nine years earlier. In 1720, the company proposed taking over Great Britain's national debt in exchange for government bonds and being granted a monopoly by the British government to trade in the South Seas (South America). This led to a buying frenzy of its shares, as outlandish claims for its potential profits spread among those with money to invest. Shares rose from almost £130 to more than £1,000 at its peak.
However, news then spread that the company's prospects were far less rosy than the company was promising. The market for its shares collapsed, and the company was accused of falsely inflating its prices by spreading rumors about its success. The event led to significant financial reforms in Britain to prevent its reoccurrence. This included the ban on naked short sales.
France and Napoleon's Ban on the "Treasonous" Practice
Frustrated by speculators betting against government securities in his early years in power, Napoleon Bonaparte outlawed short selling in 1801. He viewed short sellers as nothing short of enemies of the state, equating their activities with treason, though their speculative wagers targeted his government's economic policies as much as anything.
Imprisoning short sellers was part of his broader efforts to stabilize and control France's financial system in the lead-up to his European military campaigns. Napoleon's ban reflects the long-standing suspicion and controversy surrounding short selling, especially by those who see it as a critique of their own management.
The US's Long Story on Shorts
Early in the country's history, the U.S. banned short selling as its new stock market gained its footing because of the speculation caused by the War of 1812. The prohibition stayed in place until the 1850s when it was removed for the next eight decades. In October 1929, the market crashed, and among the many blamed was stock trader Jesse Livermore, who collected $100 million shorting the market that year. As word of his prodigious returns spread, so did outrage as countless investors were left penniless.
As Congress investigated the market crash of 1929, their attention turned to reports of “bear raids,” collusion among short sellers to drive a stock price down and profit from the drop. In 1934, Congress created the Securities and Exchange Commission (SEC), giving it the power to regulate short selling through the Securities Exchange Act of 1934.
The SEC adopted its uptick rule in 1938 to combat unrestricted short selling. Known as Rule 10a-1, the regulation forbids shorting a stock unless the last trade was at a higher price than the previous trade, which was meant to slow the momentum of a security's decline. Short sales on downticks, with some narrow exceptions, were prohibited, preventing short selling at successively lower prices, a strategy that could drive a stock price down artificially. Meanwhile, by permitting short selling when a stock was going up, the rule aimed to support liquidity and allow shorts that were a check on upward price swings.
Subsequent SEC Investigations and Regulations
Despite the legal acceptance and recognition of some of the benefits of short selling, skepticism persisted among policymakers and the public, who disdained profiting from the losses of others as unethical. In the decades after the SEC was formed, Congress revisited the practice several times. In 1963, Congress directed the SEC to study short selling's impact on price trends, which revealed an increase in short sale ratios during market declines.
In 1976, another Congressional investigation looked into the effects of eliminating or revising the uptick rule. Stock exchanges and investors objected to any changes, arguing that the rule was essential for maintaining market stability and investor confidence. The SEC withdrew its proposals in 1980, leaving the uptick rule in place. Seven years later, the Black Monday stock market crash of 1987 again brought short sellers unwanted attention in Congressional hearings. However, the practice remained in place much as before.
Debate over the uptick rule grew in the 2000s, as technological and market changes, according to critics of the regulation, made the rule obsolete and inefficient. The SEC launched a pilot program in 2005, exempting one-third of Russell 3000 stocks from any short sale price tests. The pilot program was an element of Regulation SHO, which aimed to modernize and simplify the regulations on short selling.
Repeal of the Uptick Rule, Regulation SHO, and Rule 201
The SEC finally eliminated the uptick rule in 2007 after its yearslong study concluded that the regulation did little to curb abuses and perhaps limited market liquidity.The study found no evidence that short selling contributed to market volatility or price declines.
But these changes arrived just in time for the 2007-8 financial crisis. As Lehman Brothers, one of the largest Wall Street investment banks, collapsed, its CEO, Richard Fuld Jr., blamed his 158-year-old company's fall on short sellers. While his fuming caught wide public attention, later studies showed little connection to the collapse. Lehman itself was investigated for facilitating naked short sales before its demise. As in previous crises, the public and its representatives were galled that short sellers could be making money when others were facing the hardships of an economic crisis. In time, this view would change. By 2015, the film “The Big Short,” based on the book of the same name by Michael Lewis, portrayed short sellers as unheralded heroes during the height of the previous decades' mortgage boom.
Academic research on short-selling bans generally finds that such prohibitions don't significantly alter market dynamics, reinforcing the complex nature of regulating short selling practices. Studies by the Federal Reserve also revealed that short-selling bans negatively increase market volatility and fail to stop downward price spirals as intended.
Several major changes took place during this period. Regulation SHO, adopted in 2004 and implemented a year later, had already set out to modernize regulations around short selling in the U.S. The regulation required brokers to have a reasonable belief that an equity to be short sold could be borrowed and delivered on the settlement date before they could execute a short sale. This was aimed directly at curbing naked short sales. Regulation SHO also mandated that, should a security not be delivered by its settlement date, the broker would have to buy shares in the open market to make good on the failure within a specified time.
In 2010, the SEC added Rule 201, called the “alternative uptick rule,” to Regulation SHO. When a stock's price drops more than 10% from the previous day's closing price, the alternative uptick rule restricts short selling of that stock to prices above the current best bid. This was meant to keep short sellers from driving a stock price down rapidly.
The SEC adopted regulations in October 2023 that required institutional investors to report their short positions monthly after the early 2020s “meme stock” saga. The SEC also began requiring institutional investors and other companies involved in lending stock to report information about the loans to the Financial Industry Regulatory Authority, including the name and volume of the stock, any collateral used, and the loan and termination dates.
Short selling can reveal flaws or red flags in a company missed by others. For example, Enron once had deep political connections, a seemingly unshakeable business model, and executives frequently found on the covers of financial magazines. When a prominent short seller, James Chanos, saw something amiss in the company's accounting practices, his actions helped uncover the accounting fraud of the Enron scandal, which eventually put some of its executives behind bars.
The Positive Role of Short Sellers
Short selling bans have been used to address abuses such as betting against a stock and then spreading negative rumors about its worth to manipulate the market. However, many bans are repealed because short sellers have a significant role in the markets. The SEC has cited the following in judging the importance of their role in the contemporary marketplace:
- Efficient price discovery: By betting against overvalued stocks, short sellers help correct mispriced securities, contributing to more accurate market valuations and better, more efficient price discovery.
- Helping to pop market bubbles: They can help deflate overvalued assets, reducing the risk of market bubbles.
- Increasing market liquidity: Short selling increases the number of sellers in the market, improving liquidity.
- Moving capital to where it's needed: By helping to correct overvalued stocks, they indirectly aid in efficiently allocating capital to other assets, potentially those currently undervalued.
- Facilitates hedging and other risk management tools: Investors and fund managers frequently use short selling as a hedging tool to manage portfolio risk.
- Limits upward market manipulation: Short selling can counterbalance or prevent unjustified upward price spirals, making markets less susceptible to hype and manipulation.
Why Do Critics Call for Banning Short Selling?
Some argue that short selling should be illegal because of its potential to manipulate market prices, worries that it may exacerbate market declines, and the seeming unfairness of profiting from others' losses. The practice is also viewed as harmful to companies and investors, especially during volatile market conditions. Critics often associate short selling with predatory behavior and say that it can undermine confidence in the market. Conversely, proponents argue that short selling provides liquidity, helps in price discovery, and exposes overvalued stocks or fraudulent practices within companies.
Why Did the SEC Repeal the Uptick Rule?
Based on its research and academic studies, the SEC concluded that the rule was ineffective in curbing abuses and that it could constrain market liquidity. Bans on short selling have often been found to lead to a decrease in market liquidity, as they limit the ability of investors to express through short sales, their negative views of a stock.
How Did Regulators React to the 2008 Financial Crisis in Terms of Short Selling?
During the 2008 financial crisis, many countries, including the U.S. and several European nations, adopted temporary bans on short-selling to help stabilize the markets.
The Bottom Line
Short selling, a practice dating back to the earliest days of stock markets, typically faces scrutiny and temporary bans, especially during market tumults. Every country sets the rules and regulations for short selling. Critics argue it fosters market manipulation and profiteering from others' misfortunes. Yet, its legality in most regions today underscores how regulators find it crucial for supporting market efficiency and liquidity. The practice, proponents say, aids in efficient price discovery, helps prevent market bubbles, and supports risk management. While debates about short selling will no doubt continue, evolving regulatory oversight by the SEC has aimed to balance leveraging its benefits and mitigating potential abuses while ensuring a more transparent and resilient financial market landscape.
