Not so many years ago, for most of us a “short” was the caffeine boost we sought after a hard night out – or perhaps a reference to a 1995 movie with John Travolta and Danny DeVito.
However, thanks to more recent Hollywood productions, such as The Wolf of Wall of Wall Street and The Big Short, we have become aware that “The Short” – properly described as short selling – is a potent factor in the day to day operations of the investment markets of which most of us are a part, if not directly, then through our superannuation. Short selling raises serious issues of public policy and the regulation of those investments markets.
These issues came into sharp focus, in January this year when an obscure and plodding American company, GameStop, brought short selling to the centre of our attention.
But what is short selling, and how does it work?
The starting point is that a stock market investor, typically a hedge fund, considers that a stock is over-priced, and likely to fall. Even though this investor doesn’t own any of that stock, it sells on the market, with a view to buying back at a lower price in time to deliver on its sale. That is a “naked” short sale, and self-evidently is a very hazardous practice. In fact our investor will typically borrow the stock it wants to sell from another institution that has plenty of the stock in its portfolio, and which charges a fee for the service. The investor has thus “covered” its obligation to deliver the stock it is selling. In due course it buys back at a lower price (assuming all goes to plan), hands back the borrowed stock to the institutional lender, and pockets a profit.
Let’s say our hedge fund investor thinks Widgets Limited is trading at an overvalued price at $20 per share, and that it will drop in price. The hedge fund borrows 1,000,000 shares from an institution and sells on market at the current $20 price. Widgets Limited duly falls to $15, and the hedge fund buys back at that price – a $5 million profit, less the relatively modest fee for the loan of the shares. However, if the Widgets Limited price goes up by $5 per share, the hedge fund takes a $5 million loss.
This is very much a game for big kids – retail investors need not apply. It is only worth doing if the volumes and dollars are large, so short sellers are typically hedge funds or other institutional investors specialising in this dark art. Moreover, it is only substantial institutions that have the clout and credibility to borrow the stock essential to bridge the gap between sell and buy.
Once one short seller starts selling, others pile on, so the volume of short-sold stock multiplies and the price falls faster and further. Whatever the merits of the initial assessment of the company, the short sell can become a self-fulfilling prophecy.
Holders of stock in the target company can experience a substantial and sometimes irrecoverable loss of value. The company itself may become vulnerable to takeover. The short seller can make large profits, but if it makes the wrong call it will suffer substantial, even fatal losses. And the failure of any participant in the globally interconnected financial system creates ripple effects that can threaten other participants, and destabilise the entire system.
So, it is not surprising that short selling becomes the subject of strong and contrasting opinions. Some market commentators consider short selling a cancer on the financial system, tantamount to insider trading or market manipulation. The alternative view is that short selling is an essential tool in identifying otherwise unrecognised problems in public listed companies, and thereby enabling the market to price these stocks accurately.
The regulatory response in Australia falls closer to the second view than the first. Short selling is permitted, but subject to close supervision by the Australian Stock Exchange and the Australian Securities & Investments Commission. Short sales must be reported daily to the ASX, as must short positions (i.e. where the quantity of stock an investor is holding is less than the quantity it has to deliver). Naked short sales are generally prohibited, except where the risk of non-delivery is mitigated in some other fashion.
Those regulatory controls (which are largely replicated through financial markets globally) are focussed on the short seller. However, the GameStop incident has raised questions about the other side of the buy/sell equation.
GameStop is an old-style computer games business, based on a network of bricks and mortar retail stores throughout the US and elsewhere in the world – there are quite a few in Australia, trading as EB Games. It would not be surprising if GameStop had long since gone the way of the dodo and the video rental store, but it has somehow hung on. As such, it was an obvious target for short sellers, and by the end of 2020 two hedge funds in particular – Melvin Capital and Citron Research – had built up very large short positions in GameStop.
However, at the same time, through the COVID pandemic, thousands – perhaps even millions – of computer-literate and comparatively young people (mostly but not exclusively male, it seems), got bored with sitting home playing online games. So, they turned their attention and talents to share trading, using no-fee online trading platforms that are available in the USA (although not currently in Australia), and sharing ideas in internet chatrooms.
For an earlier generation, the best analogy may be sitting on the couch on a Saturday afternoon, watching the races on Channel 7, and placing phone bets with the TAB.
Perhaps because of a sentimental attachment based on happy teenage hours spent in GameStop stores, one of the ideas that gained traction in the chatrooms – particularly that known as WallStreetBets – was that the GameStop short play could and should be countered by a concerted buying campaign. So, when hundreds of thousands, or millions, of retail investors each invested a few thousand dollars, the GameStop price stopped falling. Instead, it rocketed from $20 per share at the beginning of January to a high of over $500 on 28 January when the major trading platform, Robinhood, suspended trading.
The short sellers, particularly Melvin and Citron, were themselves caught out in a classic “short squeeze”, as they scrambled to buy the stock they needed to meet their obligations to the stock lenders. Their total loss is estimated at $6 billion. On the other side, some of the WallStreetBettors, at least, made a lot of money – but those who were late getting in on the game probably lost their shirts when the stock price inevitably started to fall again.
This was all good fun but it did have serious implications. If a major hedge fund defaulted on its obligations (such as to return its borrowed stock to the lender) the flow-on consequences could be far-reaching.
This was a real risk in the GameStop situation – Melvin Capital lost an estimated 53% of its investment value in January 2021, and had to be rescued by an injection of $2.75 billion from two other Wall Street institutions.
In the aftermath of the GameStop affair, some market commentators and US politicians have suggested that the actions of the WallStreetBets traders amounted to market manipulation, and that more regulation may be necessary to prevent this happening again.
Could it happen in Australia?
COVID-induced volatility, a low interest rate environment, and the desire to learn a new skill while in lockdown have seen investor numbers in Australia reach a record high of 1.25 million, with 435,000 first-time traders entering into the share market in the past 12 months. Significantly, 18% of first time traders were under 25 years of age and 49% were aged between 25 and 39, both demographics that are comfortable with online trading and social media. The similarities with the WallStreetBets investors are apparent.
However, expert commentators consider that other factors that gave rise to the GameStop squeeze – including the massive volume of retail investors and the availability of fee-free trading – do not exist in Australia, and are unlikely to in the foreseeable future.
Nonetheless, the regulators are watching – having already seen the artificial inflation (mostly due to social media speculation) of stock prices such as a2 milk, Afterpay & others in Australia, ASIC has expressed the need for more regulation to ensure that people who may be giving recommendations, ramping up stock and manipulating prices in social platforms are caught by Australian financial services law, and face appropriate penalties.
Perhaps the GameStop short squeeze was a one-off event, resulting from the unique circumstances of the COVID-19 pandemic, to be looked back on nostalgically in thirty years time. On the other hand, it may point the way to a future where online trading, social media and mass participation have irrevocably altered the dynamics and structure of the public-traded markets.