May 1, 2009
Naked short selling exaggerates the supply of a stock and thus distorts the basic supply/demand based market mechanism. For example, naked shorting effectively increases at that time the supply of the stock in the market, shifting the supply curve to the right. Thus, the equilibrium price is lowered, as the demand curve is downward sloping. This in turn affects the tastes and preferences for the stock, meaning that fewer investors prefer it, and therefore more sell, shifting the demand curve to the left, providing a still lower equilibrium price and quantity. A self-reinforcing feedback loop is thereby created, resulting in even lower prices and exaggerations of supply as more short sellers pile on and investors further abandon the stock.
One may argue that, in theory, the markets are efficient and this problem would be self correcting. I challenge that view for the following reasons.
First, I disagree with the contention that the markets are efficient (particularly in the short tun) and, even if so, there are distributional consequences that are not justifiable--in the aggregate the market may adjust but the short selling favors one group (hedge funds, institutions, etc) over another that does not have access to information as quickly as others. Further, technical analysts and investors who follow technical analysis focus on price and volume as signals of stock value, so extraordinary selling signals and precipitates further selling.
Second, short selling creates a time differential in price, which rewards one group at the expense of another solely on the basis of the ability to exploit that time differential. Any contribution it may make to efficiency by signally problems with a stock is more than outweighed by the potential for abuse, particularly at the expense of noninstitutional investors, 401(k) plan participants, and smaller investors.
Finally, the manipulation of price has second round effects that extend beyond the stock market issues, such as affecting creditworthiness (covenants may be contingent on market cap or stock price), labor (incentive compensation such as stock options are distorted and companies may lose critical talent), and customer retention and goodwill (a collapsing stock price may signal to customers that the company will be unable compete, honor its warranties, etc).
In summary, naked short selling exaggerates the quantity of the stock in the market, suppressing its price and creating a negative feedback loop that further depresses the price, and there is little or no compensating benefit. It should therefore be banned, absent some justification that I have, thus far, been unable to identify.
Thank you for considering my comments.