By Pedro Saffi, Professor at IESE A year and a half ago, when we commented in this section on the consequences of restricting short selling, no one suspected the impact this issue would soon have on financial markets. Today, short selling is in the news more than ever as a result of the current economic situation and the restrictions that the US, UK and Spain have imposed on this type of operations. Prof. Pedro Saffi takes a new look at short selling to reveal what is behind these transactions, what is happening now in financial markets and the particular case of Spain.

Short selling is an easy way for investors to make money on a fall in asset prices. It involves borrowing shares, selling them and, if their price falls, buying them back; then you return them to the original lender and you gain the difference. For example, say you sold shares at $100 each and now they are worth $70; you go to the market and buy them back for $70, you return them to the person who lent them to you and keep the difference of $30.

The lenders of these shares tend to be long-term investors who charge a fee for lending their shares. Borrowing shares is very cheap, at least in major markets, with annual fees around 1%. If everyone thinks that prices are going to fall, the demand for borrowing shares will rise, and in this case lenders take advantage of the situation to raise their fees for lending their shares to investors.

Most academics approve of this type of transaction for two reasons:

1. It allows negative information into the market faster. If we prevent investors from operating, we’re pushing them out of the market. Investors are not stupid. If everyone starts to see that a company or government is going through rough times, investors quit the market before they lose all their money.
2. For questions of liquidity. We know that most investors who engage in short selling are those that make a lot of transactions. If they cannot sell short, they cannot buy either. In the US, research shows that hedge funds account for between 30% and 40% of daily market volume.

 
Naked short selling

But what about naked short selling? This variation of short selling involves selling shares without having borrowed them first, because since the investor has from 2 to 3 days before the purchase becomes effective, he or she has that period of time to find a lender from whom to borrow the shares. The first market to ban naked short selling was the US in 2007, coinciding with the start of economic problems.

In this case, the ban on naked short selling makes some sense.  It’s alright if you want to sell shares short, but first you must make sure you have them located. The problem is that in these times of crisis it is often difficult to locate such shares.

To ban or not to ban?

The UK was the first country to ban short selling, followed on the same day or the day after by the US. If you cannot sell short in these countries, you will probably look for other countries where you can. Thus, the inability to engage in the short selling of bank stocks in the US and Britain caused many investors to look into the Spanish market. This is one of the reasons that led the Spanish authorities to establish rules governing such operations in Spain.

In particular, the Spanish National Securities Market Commission (CNMV) has agreed on a series of measures, including the following obligations:

1. To disclose all short positions on any share or participatory shares admitted to trading on official Spanish secondary markets.
2. To notify the CNMV of all individual short positions in excess of 0.2% of capital admitted to trading or when a previously reported position falls below that percentage.
3. To post on the CNMV website all notifications received in excess of 0.5% of the issuer’s capital admitted to trading.


Investors complain that it is not going to be easy to compile all this information and at the close of each day they must report how much they have sold. Difficult as this may be, it is doable; the problem is that the costs may exceed the returns on short selling.

In sum, short selling is not a problem itself. It is not due to this sort of operations that prices fall, rather the cause is found in other factors. The rise of short selling is a consequence of current overall circumstances.  Investors take advantage of this situation and try to make money out of it, because they believe a company’s financial situation is likely to worsen.