SEC could tank market through short sellers rule, discouraging the essential function of discovery by risk takers.
Up front, Gary Gensler’s SEC has voted 3-2 to force public disclosure of this highly important investment strategy. Wise minds will hopefully prevail here.
For now, consider the risk. When an investor “shorts” shares, this individual goes to the market in search of shares to borrow, pays the owner of the borrowed shares a rate of interest for the shares, sells them, and then hopes the shares will decline in value. The frequently elusive profit is in the difference between the price at which the borrowed shares were sold, and the price of the shares subsequently purchased in order to return borrowed shares to lender.
Hopefully the risk is obvious by now. While there’s potential to profit if shares borrowed and sold subsequently decline, it’s also possible that the short seller is wrong. Very wrong.
To see why, consider that “buy-and-hold” is an investment strategy as old as markets. Human progress happily means there’s an upward tilt to equity markets that short sellers run against. The potential losses on a short sale are unlimited. Not enough for you? Short sellers of TeslaTSLA in 2019 were ubiquitous, only for the shares to go on a run that at times lifted the company’s valuation to over $1 trillion…
Keep the crucial importance of short sellers well in mind with the SEC’s recent mindless decision to force hedge funds to disclose the companies whose shares they’re short. What a short-sighted and dangerous move, one that could be very harmful to mainstream investors and the economy more broadly. Think about it.
While there’s a bullish, progress-laden tilt to equity markets, short sellers are paradoxically an essential source of that bullish tilt. They are because equity markets gain strength from periods of weakness as the mediocre and bad are exposed so that they can be replaced by the good and great. Short sellers courageously stand athwart conventional wisdom with an eye on exposing what perhaps rates replacement.
Crucial for those who naively imagine that short sellers profit from pain and market corrections, it can’t be forgotten that they borrowed the shares sold. Which means that in order to complete transactions meant to express their pessimism, short sellers must eventually return and buy the shares initially borrowed and sold. Put another way, short sellers are the antidote to equity-market pain precisely because their buying puts a floor under markets in decline.
The new SEC rule would place a big tax on their essential work. Never forget, a short sale itself is very risky. Plus there’s a rate of interest paid to borrow shares, a rate that goes up and down depending on the availability of shares to borrow.
Disclosure rules for hedge funds would logically raise the cost of borrowing shares as they build short positions, thus raising the risk of doing so. Particularly if the short seller forced to disclose is well regarded.
Disclosure rules would potentially force this individual to pay more to borrow shares, not to mention the cost of closing a short-sale if copy-cats attempt to mimic the actions of the expert.
Stating what should be obvious, investing is all about the search for and discovery of value. By raising the cost of price discovery that short sellers play an essential role in, the SEC will blind the very markets reliant on clarity in order to progress.
Originally published by RealClearMarkets. Republished with permission.