Short selling isn't a new phenomenon; it's been around ever since the origin of the stock market. However, the sellers' pessimism that goes along with short selling hasn't always been welcomed.
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.
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 certain 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 is a trading strategy in which an investor bets that a stock's price will decline. It's a practice that exists in a variety of markets around the world and has existed since the earliest days of trading.
- Short selling has been in practice since stock markets began in the Dutch Republic in the 1600s. Shorting of the Dutch East India Company, among other stocks, led to the temporary ban of short-sellers.
- In the 18th Century, Great Britain banned naked short selling, in which shares being shorted are never borrowed by the short seller. In France, Napoleon Bonaparte outlawed short selling amid the French Revolution.
- In the U.S., short selling was first banned during the War of 1812, was restricted during the Great Depression, and was subject to more scrutiny and regulations following the market crashes in 1987, 2001, and 2008.
The Dutch Republic
Short selling has been around since the stock markets emerged in the Dutch Republic 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 stock. They attempted to drive share prices down by selling large quantities of shares on the market. The Dutch government took action and instituted a temporary ban on short selling.
Many governments over the years have taken actions to limit or regulate short selling, due to its connection with a number of stock market selloffs and other financial crises. However, outright bans have usually been repealed, as short selling is a significant part of daily market trading.
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 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 £1,000 at its peak. Then the market collapsed. The company was accused of falsely inflating its prices by spreading false rumors about its success.
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 treasonous. He even had short 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 to be 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.
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 slow down the momentum of a security's decline.
A U.S. congressional hearing addressed short selling in 1989, following the stock market crash of 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 sector securities. These countries include the U.S., Britain, France, Germany, Switzerland, Ireland, Canada, and others that followed suit.
Short selling can sometimes reveal underlying flaws in a corporation, such as when a short seller named James Chanos saw something was amiss in Enron's accounting practices. His actions helped uncover the accounting fraud known as the "Enron scandal," which put its executives behind bars.
The Big Picture
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.