Intro to Investing: Should Short Selling Be Banned?

By Will Hodgson


In the current economic climate around the world, inflation rates are rising and recession feels imminent, it’s crucial that the government takes every action necessary to ensure citizens can maintain a reasonable standard of living. One such action that has gained traction recently, is the banning of short selling stocks.


For those who don’t know, shorting a stock is the process of borrowing the stock from a broker and selling it, expecting the price to decline for them to repurchase it at a lower price.


History


Through the eras of financial markets, short sellers have been at the crux of blame for financial fallouts. In some cases, governments around the world have halted short selling to allow for markets to strengthen and recover.

The first ban of short selling was in 1610, during the crash of the Dutch East India Company, where one of its key executives Le Maire was blamed for manipulating the stock to drive the stock down. Additionally in France leading up to the French revolution, Napoleon Bonaparte outlawed short selling and had short sellers imprisoned.


The US is the largest stock market in the world with 59.9% of the total world equity market, followed by Japan at 6.2%. Similarly, to France and the Netherlands, it has had a longstanding history of turmoil with short selling. It was banned in the war of 1812 to remove instability from the market and stayed in place until the 1850s. It was then restricted again leading up to the Great Depression in 1929. Moreover, in both the stock market crash of 1987 and 2008 GFC, short selling received temporary bans.


The Securities and Exchanges Commission in America has imposed a strict set of laws that limit a seller’s ability to abuse short selling and specific forms such as “naked short selling” (shorting a stock without initially borrowing it). However, they do acknowledge that short sellers provide necessary contribution to financial markets as they allow for the efficient discovery of price stability, mitigate market bubbles, increase market liquidity, promote capital formation, facilitate hedging and management activities and limit upward manipulation.


Application


At the time of writing this article, the current state of both the Australian and global economy is extremely unstable. Inflation and interest rates are rising, and the dark cloud of a recession seems to be constantly looming over the horizon. As a result, investor confidence has started to slump dramatically, with the ASX 200 decreasing by 14.7% since January and a monumental 33.51% decrease in the NASDAQ-100 (as of 30 September).


Is this a basis to implement another temporary ban on short selling?


To consider whether banning short selling is applicable, it’s prudent to determine the factors that have both driven up and down stock prices since the incidence of COVID-19. As people lost their jobs, governments implemented a massive amount of quantitative easing within the economy to provide a stable economic environment for consumers: interest rates were brought to almost zero and job-keeper and housing supplements were paid out. These factors, among with many others, placed many people in situations where they wouldn’t have been financially had they have not received them. The impact can be best seen in the housing market, which observed an increase of 23.7% in 2021 alone due to the rise in demand and purchasing power of consumers.


Not only did people have excess capital for housing, but they had money to purchase stocks, hence the huge increase in the share of US equities from retail investing of 10% since 2019.


The macroeconomic conditions over 2020 and 2021, from both the information discussed and a myriad of other factors, have clearly provided many people with increased purchasing power which caused an unjustified increase in stock prices and the formation of a price “bubble”.


Summary


As a result, I personally do not feel that there is reason enough to ban short selling, as it is currently allowing prices to fall back to their natural level; evidenced by the steady decline of prices and not a rapid decrease. With that said, if markets were to become extremely volatile and a depression hit, the restriction of short selling may not be a bad idea, as it would provide financial stability for companies that operate within markets.


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The views expressed within this article are those of the authors and do not represent the views of the Finance Student's Association. All images and references in this article are for fair and educational purposes only. The content in this article is not intended as legal, financial or investment advice and should not be construed or relied on as such.


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