Why it would be a dumb idea to ban short-selling

Last year was a frustrating one for many investors outside the ASX blue chips, so when news broke that South Korea was banning short selling, debate was reignited among the executives of some beaten-down companies as to whether Australia should do the same. That would be a bad idea.

In November, the South Korean regulators announced they would ban short selling, the practice whereby one profits from a falling share price, until June 2024. They claimed that “short selling makes it difficult to form fair prices” and is “highly likely to hurt individual investors”.

The film Dumb Money dramatised the GameStop short-selling squeeze. Comedian Pete Davidson (left) plays the dropkick brother of the GameStop craze instigator Keith Gill. Paul Dano is in the latter role.
The film Dumb Money dramatised the GameStop short-selling squeeze. Comedian Pete Davidson (left) plays the dropkick brother of the GameStop craze instigator Keith Gill. Paul Dano is in the latter role.Credit: Roadshow Films

The following day, the South Korean market jumped 5.7 per cent – the largest single day gain in more than three years.

Our benchmark ASX index was only up 7.8 per cent in 2023 despite a greater than 24 per cent rise in US markets. The more speculative end of the market, where more retail investors play, was down still down on the year, with lithium and critical minerals stocks hit especially hard.

In December, Alex Dorsch, the CEO of Chalice Mining, came out in support of a Korean-style ban in Australia, arguing it was “in the national interest”. Coincidentally, Chalice’s shares are highly shorted, with the latest data from the Australian Securities and Investments Commission showing that 6.5 per cent of the company’s shares are held short.

It’s fair to say that Dorsch feels his Chalice has been poisoned by short sellers. He argues that pre-revenue companies (also known as loss-making companies) such as his, should be protected from “geopolitical opponents” who might try to stymie the development of Australian miners by shorting them out of business.

Shares in the critical mineral’s developer were down more than 73 per cent in 2023 and are already down another 30 per cent since the beginning of this year. The catalyst, a more than 25 per cent plunge in a single day in August 2023, when Chalice released a scoping study that contained rather optimistic assumptions for the future price of the palladium to be produced by a prospective mine.

In the same way bulls take long positions when they believe a company is undervalued, short sellers identify companies they believe to be overvalued.

If your company has been the target of short selling, or if you are an investor of a stock that has been underperforming because of short selling, the idea of banning it is tempting indeed. But short selling plays a vital role in price discovery, hedging and liquidity.

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Research has found that when hypothetical constraints on short selling are lifted, market crash risks are reduced and overvaluations more unlikely, as less bad news is hoarded by management. Short sellers have been instrumental in uncovering some of the largest market frauds, exposing wrongdoing by companies such as Eron.

Following Dorch’s calls, Peter Coleman, the chairman of Arcadium Lithium (formerly Allkem), defended short selling, telling The Australian Financial Review that “short selling makes a market transparent”, and that “is all very natural as business models are tested, and the stronger companies move forward”.

For an executive of a company in a sector such as lithium that has been the most targeted by short selling to come out in its defence speaks to the important role it plays in the functioning of a free market. In the same way bulls take long positions when they believe a company is undervalued, short sellers identify companies they believe to be overvalued.

Three of the top five most shorted stocks on the ASX are lithium companies, with shorters targeting them as proxies for the “white gold” commodity that slumped 85 per cent last year, not due to “market manipulation” but rather the simple economics of supply and demand. It was the most obvious trade of the year.

By betting against irrational hypes, such as the lithium frenzy, short selling prevents excessive valuations and acts as a counter to overly optimistic investors, holds management to account and encourages greater due diligence from investors.

As a “bag-holder” of Core Lithium, the third most shorted stock on the ASX (about 13.8 per cent of shares held short) and one which is down more 75 per cent year-to-date, you might expect me to be the first person to support a short selling ban. But part of growing as an investor is accepting that one made a bad decision against a prevailing trend, instead of blaming “predatory short sellers” or a market that “is out to get me”.

Former Enron chairman Kenneth Lay (centre) was convicted of conspiracy and securities and wire fraud in one of the biggest business scandals in US history.
Former Enron chairman Kenneth Lay (centre) was convicted of conspiracy and securities and wire fraud in one of the biggest business scandals in US history. Credit: AP

It’s important for “long only” investors to check the short interest in stocks they have a bullish investment thesis on, what do they know that you don’t? It’s a question I should have considered more thoroughly.

And it’s not like shorting is easy money.

Shorters cannot hold stocks indefinitely like long-only investors – they pay additional interest fees, and are exposed to infinite losses should a “short squeeze” occur (remember GameStop). These additional risks mean short sellers do their due diligence and don’t take positions lightly.

It has been estimated that US short sellers made US$300 billion ($457 billion) betting against the market in 2022, but following the Fed pivot that fuelled a monster eight week rally to the end the year, short sellers have been left about US$195 billion in the red.

The real problem with shorting is that it’s not readily accessible to most retail investors, further perpetuating that idea that it is one set of rules for us, and another for the hedge funds.

While it is possible to take bearish positions against the Australian market through short ETFs (exchange-traded funds), the option to short individual stocks isn’t offered by most brokers. Instead of banning short selling, greater access to shorting for retail would level the playing field. As with free speech, just because you may disagree with it, the solution isn’t a ban, but rather increased speech.

In a free market, anyone should be able to express positive and negative views on stock prices and profit from doing so. Banning short selling would remove a critical source of information for price discovery and make our market less transparent.

That’s the long and short of it.

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Source: Thanks smh.com