Reflections on the Shorting Mechanism

The recent short squeezes involving the shares of GameStop, AMC, and Nokia stocks has been met with a few mass media-fueled responses: (1) debate over the appropriate role of regulation in response to retail investor-induced volatility; (2) debate over the role of the traditional hedge fund industry, and whether these financial services are more parasitic than beneficial to market clearing; (3) criticism of Robinhood’s decisions to exert authority over its customers’ accounts, which has been deemed as a blatant violation of their customers’ trust; (4) criticism of the shorting mechanism itself, especially from industry leaders such as Elon Musk, which has been described as an unnecessary or exploitative financial mechanic. I want to reflect on this last response, as the shorting mechanism, while blatantly exploited and requires salient reform, is a necessary mechanism in financial markets.

Elon Musk’s motivation for criticizing shorting is fairly self-evident; in 2020, he experienced one of the fastest accumulations of wealth in human history due to the tremendous rise in Tesla’s share price. As such, he is understandably critical of stock shorting. Similarly, business leaders have criticized the excessive shorting of shares of GameStop, et al., as more shares of GameStop were shorted than shares of the stock exist. This type of over-shorting trespasses the boundary between the initial value of the shorting mechanism, which is to prevent speculative overvaluing, and a potential predatory practice where excessive shorting artificially squeezes value out of the business. Therefore, in circumstances such as these, a collective “short squeeze” is not just a viable “free market” solution (in the absence of appropriate regulation), but a necessary counter to an otherwise predatory use of the shorting mechanism.

So why do we need shorting anyways? Simply put, it serves as a counterbalance to an endless “party” — it theoretically allows investors to more accurately value securities, companies, markets, etc., as it provides a way for folks who believe an asset is overvalued to express their position. Theoretically, if asset prices continued to keep rising way past their real value (e.g. the housing market prior to the 2008 financial crisis), any exogenous shock to their valuation (e.g. the mass foreclosure of houses prior to 2008 financial crisis) will have tremendously devastating consequences to both institutional investors and (more importantly) the average household with their savings tied up in that particular asset. I say “theoretically,” because, despite the “shorting mechanism” being a staple of financial activity since the first share of stock was issued in the early 17th century, financial asset markets across the world have always been susceptible to the “endless party.” Every major asset price crash since the 17th century has been accompanied by economic disaster, deepening socioeconomic divides, and a general decline in welfare. This raises the question, of whether “shorting” actually works as its theoretically model would suggest. If it doesn’t, then what utility does it bring? And if it does work, why do we still consistently experience financial calamities and crashes?

Let’s consider the origins of the practice.

During the early 17th century, the Dutch stock exchange consisted of only one company, the Dutch East India Company, which, at the time, exercised monopoly power over the spice trade in Europe. While the Dutch Republic was a fairly small state in comparison to its imperial neighbors, they nonetheless held strategic holdings across the Indian Ocean, South America, the African coastline, and Indonesia. The placement of their early strategic holdings, coupled with a naval supremacy surpassed only by Great Britain, allowed them to monopolize the movement of black pepper, chilies, cloves, nutmeg, and the myriad other tropical spices from around the world. As such, the Dutch East India Company, effectively the sole entity responsible for clearing spice markets, was immensely profitable. This profitability was augmented further by the Company’s involvement in trading a whole host of other consumer and luxury goods.

Isaac Le Maire, a director and founding member of the Dutch East India Company, is generally credited with engineering the first stock short in modern financial history. His motivation for doing so, however, was borne of revenge rather than any fundamental analysis of the Company. Having been dismissed from the company over alleged embezzlement, he engineered a stock short by (1) betting that shares of the Dutch East India Company would fall and (2) spreading a mix of misinformation, rumors, and insider information (to which he was privy as a former director) about the health of the Company around the stock exchange in order to trigger a sell off (and lower the price). When the Dutch East India Company caught wind of these shenanigans, their directors lobbied the Dutch government to ban short selling, arguing that the practice was hurting the most socioeconomically disadvantaged classes. Given that the Dutch East India Company was effectively an extension of the Dutch Republic’s political apparatus, they sided with the directors and banned further short selling of their stock. Le Maire’s scheme had failed.

While the origin of the short sell may only seem cosmetically related to the recent series of short squeezes, as Le Maire was not motivated by capitalizing on a belief that the price of a stock was misvalued but more so by revenge against his former employer, I believe there are two primary thematic similarities between the two anecdotes. (1) WallStreetBets viewed its massively coordinated campaign to pump the price of GameStop’s and other companies’ shares as a way to expose a perceived injustice in the financial system, and (2) WallStreetBets, like Le Maire, relied on socialized information in order to coordinate enough retail investors to effectively move the price of the stock. However, these similarities reveal more flaws with the shorting mechanism itself, rather than expound any value.

Now, in the context of the conceptual value of short-selling, this seems to be a parallel, non-convergent topic: Le Maire was unsuccessful in his scheme, not to mention he was deliberately trying to ruin the financial health of the Dutch East India Company, whereas the WallStreetBets collective was fairly successful in forcing a short squeeze of various shares of stocks, which was ultimately a coordinated effort against institutional investors who had excessively shorted GameStop. These observations raise the question, however, of whether “shorting” is the appropriate vehicle to prevent excesses in a securities market, or if shorting is just another mechanism that is prone to excess; despite shorting having some theoretical value in optimizing market efficiency, is shorting just another instrument in which we misplace value in order to justify its existence?

Perhaps a more successful example of shorting, at least at its onset, was the use of credit default swaps to short the housing market (for the uninitiated, a credit default swap allows the holder to effectively insure some other fixed income product such as a mortgage bond — if the product defaults, the holder can cash in). Expounded in The Big Short and many other popular media, the innovation of the credit default swap allowed Dr. Michael Burry and others to “rein in” the excesses of the housing market and eventually profit from its readjustment. However, while shorting proved to be a vital instrument, both to the film’s protagonists and their real-life counterparts, the way in which shorting took place lent itself to an incredible case of manipulation. The financial services firms that provided the credit default swaps were, in many cases, also the firms that securitized subprime mortgages into bonds and sold those very same bonds at marked-up credit ratings to investors. As such, any conceptual utility that the shorting mechanism may have in reining in excessive behavior was dramatically undermined by the nature of an improperly regulated (self-regulated?) industry, as the advent of the credit default swap as a shorting mechanism allowed financial services firms to insure themselves against their own reprehensible financial products. This was not unilaterally the case, as more than several financial services institutions crumbled during the 2008 financial crisis. Ultimately, the use of “shorting” in this case did not act as a way to rein in the housing bubble — rather, it allowed financial institutions to continue with risky credit practices which ultimately imploded as the borrowers defaulted in droves.

Between GameStop, Isaac Le Maire and the Dutch East India Company, and the 2008 Financial Crisis, I think there is clarity in answering the question of whether shorting is the appropriate mechanism for staving off excesses in securities markets — it’s clearly not, as the mechanism itself is susceptible to excess. While shorting may allow individuals to profit from the over-valuation of a market, a security, a company, etc., the fact that these institutions become over-valued in the first place indicates that we lack appropriate mechanisms and products to prevent excess — we only have a mechanism that allows us to profit from this excess. Similarly, while shorting may attempt to rein in excess through providing a way to express that an object’s valuation may be higher than it should be, the mechanism itself is also subject to manipulation.

Ultimately, shorting is not a perfect nor arguably even a useful instrument, as it does not address the two underlying themes across the various anecdotes we’ve observed: (1) large players in a market can manipulate information which degrades the market’s ability to accurately reflect value and (2) socialized information defines the market itself which can easily be manipulated on the basis of human sentimentality, coordination, error, etc. When considered against these two market flaws, it’s no surprise that shorting doesn’t do what it conceptually should do, which is prevent excess from getting out of hand and resulting in a financial catastrophe. Rather, it allows certain individuals to profit from some sort of crisis, either an engineered one or a pre-destined yet overlooked one. The recent GameStop short squeeze demands us to refocus how we socialize information in markets; ultimately, this story should prompt more regulatory innovation in order to reduce manipulation from larger market players and to allow for more proper valuations to manifest through an efficient, veritable transfer of information. Until we see better instrumentation for expressing assets are improperly valued, it’s unlikely we will avoid financial incidents of all magnitudes, from a short squeeze to an industry/market-wide bubble.