January 16, 2015—Reporting of so-called short trades, investments that reward sellers when a share price falls, could be enhanced in the United States without invading investor privacy, said finance professor Stephen E. Christophe, a consultant for Nathan Associates. The economy would benefit from such reporting, he said.
Christophe, who teaches at George Mason University in Fairfax, Virginia, discussed short-selling in a talk today with Nathan analysts as part of the firm’s “Economists Present” series. Short-sellers, when they complete a sale, deliver borrowed shares; the short-sellers gain if they repay the lender with lower-priced shares.
Short-selling can lead to allegations that speculators are driving down shares. In response to the financial crisis of 2008, regulators in the U.S. and elsewhere imposed various curbs on short-selling. The massive short positions of some hedge funds, along with the speed advantage held by high frequency traders who employ short-selling strategies, also arouse public suspicions that the playing field is uneven.
Research summarized by Christophe and colleagues Michael G. Ferri and Jim Hsieh in a working paper found that stock prices reacted differently in the five days after short trades depending on the type of investor—speculator or broker-dealer, for example—making the trade. Exchanges now report the daily short volume for each stock without sorting by investor class. If exchanges reported that volume by investor class and the average size of trades for each stock, the market would be more transparent for the average investor.
“Having capital markets that are viewed as fair is desirable because it allows companies to raise capital at lower required rates of return, thereby leading to greater economic output and growth,” Christophe said in remarks prepared for his presentation. He noted that some European exchanges require individuals to disclose their short positions after they exceed a certain level. Imposing such a requirement on individuals “might be viewed as overly burdensome for U.S. financial market participants.”
Stock price outcomes might vary by investor type because of the purpose of the trade. Broker-dealers known as market makers may need to borrow shares to fill customer orders, and are likely to short more aggressively when customer demand for a company’s shares is high. Stock returns turn positive after broker-dealers make large trades. In contrast, large-sized short trades by speculators—those placing bets on a share-price decline—are usually followed by large negative returns. The NASDAQ data the researchers used had no information on high frequency traders.
Christophe made it clear that the share declines following short trades can be justified and, “on balance,” short-sellers are good for financial markets.
“Short sellers should be considered good if, based on skillful interpretation of publicly available information, short selling pushes an over-valued company’s stock price back to a fair level,” Christophe said. “No average investor” should want to overpay. The selling crosses the line into abuse when short-sellers engage in “front-running”—trading on inside information.
Christophe, an authority on securities valuation, is a Nathan academic affiliate and expert witness who aids Nathan’s work supporting counsel in financial litigation. This includes cases where pension funds and other investors say they lost money because of corporate fraud, including misleading statements—later shown to be untrue—about a company’s performance. Co-author Ferri also is a Nathan academic affiliate and expert witness.