Shorting as a Practice

Why shorting SHOULD be illegal.

Shorting is NOT just a harmless liquidity event, like many people try to claim, among the many, many incorrect defenses that I see put up for the practice. Shorting is a distortion of the market. Any market.

Before I go further, I am NOT against the idea of investors having an option to essentially bet against the share price of a company, as long as it is a fair practice. In my opinion, put options serve that purpose, and they do it well…..without distorting the market.

Unfortunately, shorting is not the same, because it DOES distort the market. The more shares that are shorted, the greater distortion. Here’s why.

In theory, a company has X number of shares, for every share sold, there should be a share purchased, and everything balances out. Since the share price is, in part, a supply and demand transaction, like all other transactions, if more shares are being sold than bought, the supply is higher than demand and the price goes down, just like any other commodity. If you created a mechanism whereby the market does not balance out, but instead there are more shares sold than bought, it is INEVITABLE that the share price would go down. Investors have known that since 1609 (I get to that below).

Simply put, if I buy 100 shares from Party A, and then lend them to Party B, who sells those shares now and promises to actually buy the shares later, the shares have been sold twice, but they’ve only actually purchased once. The second “purchase” is actually a loan, which is NOT the same thing. Party B gets the income from selling the shares, now, but doesn’t have to pay for them now, they only have to pay interest on the value of the shares they borrowed.

In the case of a company like PLS, which has approximately 3B shares and a bit more than 20% of their shares shorted, this means that there have been more than 600M shares created out of thin air, and sold, but not purchased. There are currently more than 600M shares of PLS that have been sold, but NOT purchased, creating a massive imbalance in the supply and demand equation.

Eventually, there will be a short settlement, usually in the form of a short squeeze, but in the meantime, as long as there is even one share shorted, the share price is being manipulated by downward pressure, and it has a myriad of negative effects, from individual shareholders’ finances and all sorts of other individual and corporate issues related to the unnaturally low share price, the most important of which is the availability and costs of any potential CR.

This isn’t my opinion, it’s a statement of fact.

For those that are uninterested in such things, most of the rest of this post is a bit of a history lesson.

The first (documented) short seller was Isaac le Maire, a Dutch trader and investor. In 1602, he co-founded the Dutch East Indies Company (known as the VOC), the first multinational in the world; the Western World, anyway. He was the largest shareholder and served on the BOD.

In 1605, he was removed from the BOD on an accusation of illegal trading activities and embezzling VOC funds. The truth is, the company share price had exploded by 50% in less than three years, and le Maire demanded a dividend finally be paid. Most shareholders agreed, but the VOC charter essentially said shareholders basically only vote for directors, and after that, the BOD made all decisions. Period. Le Maire was the largest shareholder, but he still only had approximately 20% of the shares, and lost the argument.

Wanting revenge, le Maire tried to convince the Kings of France and England to start new competing companies (the English East India Company came from le Maire’s advances, even though he was not a part of it), and when those attempts failed, in 1609, he and nine other investors created the Groote Compagnie. Their sole reason for existing was to sell shares of VOC “for future delivery,” the first short attack, because ANYBODY could see that this would decrease the price of the shares. Le Maire still owned a substantial number of VOCs shares, as did a few of the nine partners, but a few of the partners were also the first naked shorts, making commitments to sell shares for future delivery that they didn’t even own.

As a historical note, “back in the old days,” shares had a par price, its’ inherent value, and the value that the company had to give you (in coin or silver) if you return your shares because you are dissatisfied. When le Maire started what was the first short attack, VOC’s SP was 212% of the par price. In 18 months, it was 126% of par price. In other words, the first short attack created a 40%+ drop in the share price of the world’s first multinational company. In the financial world, that’s called proof of concept.

In a nod to the current sentiment regarding shorting, the VOC only saved themselves from going below their par price, which would have probably caused a run on the company, and bankruptcy, was by doing two thing. First, VOC finally paid a small dividend. That helped for a minute, but then the villagers started showing-up at their doors with pitchforks, the VOC BOD petitioned the Amsterdam government, and when that didn’t work, they basically bribed and begged them, to outlaw the practice of shorting. Share price stability only occurred when Amsterdam finally banned the practice.

Back to the 21 ^st Century, here is the basic principal. Many will try to attack this, or obfuscate by making straw man arguments. This is the truth, the whole truth, and I welcome people to really think this out. You can parse this any way you want. Adding liquidity to a small exchange. Giving investors another option. Whatever your defense, the fact is, selling shares that you do not actually own creates a demand imbalance that is only resolved when you actually purchase the shares. In the meantime, for as long as the “short” is active and you hold “borrowed” shares, you are manipulating the market, and specifically, the share price of the shorted stock.

As an aside, there have been multiple attempts to outlaw shorting here in the States, but somehow (and I say that with the most possible contempt…$$$$), the attempts die in some financial committee or banking committee, and agreeable members get re-elected. Funny thing.