Short sellers bet against the stock. Instead of rooting for stock prices to go up, they seek an opportunity to make money by expecting a decline. Short sellers borrow the stock from a broker, sell it, and wait for the prices to drop so they can purchase the stock at a cheaper price. (Discuss if Speculators are Useless to Society)
Throughout history, these sellers have been blamed for some of the worst failures in the world's financial markets. Some company executives have accused them of driving down their company's stock prices. Governments have temporarily halted short selling to help markets recuperate and have strengthened laws against some short-selling methods. A few governments have even gone as far as proposing and enacting extreme actions against short sellers. This has occurred throughout history in various countries and industries.
Short selling has been around since the stock markets emerged in the DutchRepublic during the 1600s. In 1610, the Dutch market crashed, and Isaac Le Maire, a prominent merchant, was blamed because he was actively short selling stocks. He was a major shareholder in the Dutch East India Company (also known as Vereenigde Oost-Indische Compagnie or VOC). Le Maire, a former member of the company's board, and his associates were accused of manipulating VOC's stocks. They attempted to drive share prices down by selling large of quantities of shares on the market. The Dutch government took action and instituted a temporary ban on short selling. (Read How Investors Often Cause The Market's Problems for more info.)
In 1733, naked short selling was banned after the fallout from the South Sea bubble of 1720. The difference between naked short selling and the traditional short sale is that the shares being shorted are never actually borrowed by the short seller.
In the case of the South Sea bubble, speculation arose about the South Sea Company's monopoly on trade. The company took over most of the England's national debt, in exchange for exclusive trading rights in the South Sea. This led to a rise in its share prices. Shares rose from nearly £130 to more than one £1000 at its peak. Then the market collapsed. The company was accused of falsely inflating its prices by spreading false rumors about its success. (Learn more about the South Sea Bubble in our article Market Crashes: The South Sea Bubble.)
The stock market was shaky leading up to the beginning of the French Revolution. Napoleon Bonaparte not only outlawed short selling, but considered it unpatriotic and treason and had sellers imprisoned. Bonaparte didn't like the activity because it got in the way of financing his wars and building his empire.
Interestingly, centuries later, short sellers received far harsher treatment than imprisonment. In 1995, the Finance Ministry of Malaysia proposed caning as a punishment for short sellers, because they considered the sellers troublemakers.
Short selling was banned in the U.S. due to the young country's unstable market and speculation regarding the War of 1812. It remained in place until the 1850s when it was repealed.
The U.S. later restricted short selling as a result of the events leading up to the Great Depression. In October 1929, the market crashed, and many people blamed stock trader Jesse Livermore. Livermore collected $100 million when shorting the stock market in 1929. Word spread and the public was outraged. (Read about one of the most famous stock traders in history, Jesse Livermore, in The Greatest Investors: Jesse L. Livermore.)
The U.S. Congress investigated the market crash of 1929, as they were concerned about reports of "bear raids" that short sellers were alleged to have run. They decided to give the newly created Securities Exchange Commission (SEC) power to regulate short selling in the Securities Exchange Act of 1934. The uptick rule was also first implemented in 1938. The rule stated that investors cannot short a stock unless the last trade was at a higher price than the previous trade. The effort was meant to slowdown the momentum of a security's decline.
A U.S. congressional hearing addressed short selling in 1989, several months after the stock market crash in October, 1987. Lawmakers wanted to look at the effects short sellers had on small companies and the need for further regulation in the markets.
The SEC updated regulation for short selling in 2005, in order to address abuses by naked short sellers with the adoption of Regulation SHO. A couple of years later, it dropped the uptick rule for all equity securities. However, the SEC still monitored naked short selling (even though naked short selling is prohibited in the U.S), and within a few years the SEC took emergency actions to limit illegal naked short selling as the mortgage crisis and credit crisis deepened and fluctuations in the market increased. In the fall of 2008, the financial crisis had spread across the world, leading countries to implement temporary short selling bans and restrictions on financial sectors securities. These countries include the U.S., Britain, France, Germany, Switzerland, Ireland, Canada and others that followed suit. (Read our tutorial on Credit Crisis to get more in-depth information on this crisis.)
Short selling bans have been utilized from the beginning of the financial markets and throughout history to address abuses like spreading negative rumors about a company to manipulate markets. However, many bans are repealed because short sellers have a significant role in the markets. The SEC identifies their importance based on their:
- Contribution to efficient price discovery
- Mitigating market bubbles
- Increasing market liquidity
- Promotion of capital formation
- Facilitating hedging and other management activities
- Limits to upward market manipulation
A good example of the short seller's significance involved identifying the overpriced stock at Enron. Short seller James Chanos examined the company's accounting practices and discovered that something was amiss. Some argue his awareness helped to uncover the accounting fraud known as the "Enron scandal" which put its executives behind bars. (For more information on companies like Enron, check out our related article, The Biggest Stock Scams Of All Time.)