Is Short Selling Evil?

Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Veljko (00:00):
Would you think less of me?

Kate (00:01):
Wait, wait, wait, let's do like a proper countdown
and everything for the start.

Veljko (00:07):
There was a countdown.

Kate (00:09):
Oh, there was?
Where?

Veljko (00:10):
Yeah, you missed it.

Kate (00:12):
Oh, it's
okay.

Veljko (00:15):
We'll edit

Kate (00:16):
we can just leave it.

Veljko (00:22):
Would you think less of me if I told you that one of my first
jobs out of college was working for afirm that sold viatical settlements?

Kate (00:34):
Well, first I would need to know what are viatical settlements and then
I would make up my mind after that.

Veljko (00:41):
Viatical settlements are life insurance policies sold
on the secondary market, right?

Kate (00:47):
That sounds quite boring.
It's probably a lot better to say on thefirst day that I am working in a viatical
settlements industries and I'm workingin a secondary insurance sales industry.

Veljko (00:59):
I mean, of all the things that I was expecting,
boring was not one of those.
It's like we are tradingcontracts with human lives...

Kate (01:07):
Anything that says insurance or actuarial, falls
into that boring category.

Veljko (01:13):
Well...
viaticals, effectively whatyou're doing is you are buying
somebody's life insurance policy.
People generally get life insurancepolicies for the children usually
to leave something behind incase something happens to them.
Oftentimes they reach a place intheir lives where they feel like they

(01:35):
do not necessarily need to providefor their children anymore, right?
The children might be grown up, they havetheir own jobs, they have their financial
independence or they're alienated.
And sometimes people simply cannotafford to keep a life insurance policy
alive and to keep paying premia.
So when people want to discontinue alife insurance policy, traditionally they

(01:57):
can go back to the insurer and they willbe given back some small compensation.
But this is usually a smallfraction of the actual payout,
they would receive in case of death

Kate (02:09):
So people want to make more money, basically, they want to make
as much money as they can on the saleof their own life insurance policy.

Veljko (02:17):
Well, yeah, in some sense, traditionally, insurances were holding
their own clients hostage, because theonly place you could go if you wanted
to get rid of your life insurancepolicy was back to the issuer, right?
Sometimes in the late 80s, early 90s,you started getting these financial
intermediaries who would buy lifeinsurance policies for people that simply

(02:42):
didn't want to keep paying premia anymore.
Let's say you had a life insurancepolicy due to cash 10 million in
a couple of years, or your lifeexpectancy is a couple of years.
They might come along andsay, we'll give you 2 million.

Kate (02:56):
But you don't need to pay your premium anymore and
you get the money right away.

Veljko (03:00):
And you get the money right away, right?
I mean, at the end of the day, youknow, what's the discount rate on
your money after you are dead, right?
I mean that for some people,that money might have no utility.
For a variety of reasons, you mightwant to cash in early, either to enjoy
your remaining life or maybe even topay for medical care, and of course

(03:22):
for the financial intermediaries, thiscould be very profitable, because when
the client dies, they're going to cashin on, the full value of the policy.
And again, there isthis disconnect, right?
The person with the limitedlife expectancy is applying
a very high discount rate.

(03:43):
And of course for the financialinstitution, these could be big profits.
To be clear, for a financial institution,after you bought this policy, the sooner
the client dies the more value that is.
Because, first the simpletime value of money.
Receiving money earlier is morevaluable than receiving money later.
But on top of that, you havethe whole argument of the

(04:06):
premia that need to be paid.
When you buy somebody's life insurancepolicy, you need to keep paying the
policy premia to keep it active.
And of course, the longer thepolicy holder stays alive, the
longer you're paying premia for.

Kate (04:21):
This all sounds extremely fascinating, but we, are planning
to talk about short selling today.
What is this analogy we're making here?

Veljko (04:31):
Well, I thought that in many ways, there is a parallel here.
While short selling is a way to betthat a company's performance will
decline and to profit from the decline,when you're buying somebody's life
insurance policy, you are effectivelyprofiting once they die, right?

(04:52):
So there is a similar " profiting fromthe demise of others" aspect here.
And you're right.
I wanted to use all of this tointroduce the topic of short selling.,

Kate (05:06):
Basically this viatical settlements industry is participating in the
short position on the person's life.

Veljko (05:13):
That's a much more elegant way of saying it but there are
parallels also because this viaticalsettlements industry is controversial.
On one side, they provide avalid service to this market.
They allow people to sell, and that leadsto people getting better prices than
the monopolistic issuer would otherwise.
On the other side, there issomething intangible that feels

(05:37):
wrong about profiting fromthe demise of others, right?
And short sellers get a bad name becausethere is also an incentive to cause
the demise of companies through rumors.
There are these negative incentives andwhen you're thinking of the viatical

(05:58):
settlements industry, actually, the veryearly beginnings were extremely seedy.
Some of the early viaticalsettlement industry started in
Florida, actually, of all places.
And, we know of anecdotes of, unscrupulousfinancial intermediaries buying life
insurance policies of individuals,oftentimes who had stories of addiction.

(06:23):
They were often targeting drug addictsand alcoholics and then they were
speeding up or incentivizing their demise.
You can think about the incentives here.
You are perhaps a drug addict, right?
And you have a life insurance policy andnow you sell it for millions of dollars.
Now you have a big influx of money,

Kate (06:45):
you can buy more drugs.

Veljko (06:46):
Yes, correct.
There were anecdotes where financialintermediaries were actually accused
of facilitating or incentivizingthat and effectively shortening
the life expectancy of the people.

Kate (06:57):
I mean, they didn't make a person an alcoholic or a drug addict.
But because this person had accessto more monies, many of them
chose to spend it on more drugs,which caused their quicker death.
When we talk about short selling,we mostly will be talking about
short selling of equities.
It's less likely that thesenegative effects persist,

(07:17):
but I can see the parallels.
Basically the main question wewant to ask, in this episode
is, is short selling evil?
And this is one of the evilreincarnations of short selling, where
you facilitate a demise of a person.

Veljko (07:34):
Well, yeah, but some people in this industry were crossing the line.
You're saying, they didn't make aperson an alcoholic or a drug addict,
but sometimes they were targetingalcoholics and drug addicts and
then actually incentivizing themto celebrate, for example, right?
When they sign a big policy, they wouldsend a case of Champagne or a case of

(08:00):
whiskey to somebody who is a recoveringalcoholic, to celebrate the fact that they
have just sold a life insurance policy.
So some of these behavior,I'd say did cross the line.
Well, not to leave everybodywith the wrong impression...
that viatical settlement industryeventually became much more sophisticated.

(08:21):
By the time I was working in thelate nineties, they were, bundling.
You know, you weren't buyingone life insurance policies, you
were buying thousands, right?
A portfolio, you were effectivelybundling it into securities, right?
You were securitizing it and you wereselling tranches of funds of insurances.
So the seedy beginnings ofthat industry effectively got

(08:45):
institutionalized and cleaned up.
And yet this feeling of "I'mprofiting from an early demise
of somebody," still persisted.
And so did some degree of controversyand yes, you're right, we are
asking, is short selling evil?
Is short selling immoral?
And then, yeah, it always did strike me.

(09:06):
Some people do accuse short sellersof being immoral and well, if betting
against the life of a company isbad, betting against the life of
a person is probably a lot worse.

Kate (09:17):
So is the conclusion here then, if, your new date tells you that they
are working for a viatical settlementsindustry, you should ask them which
year they started, because if theystarted kind of way back in time,
your opinion of your date declines.
But if they tell you that they have justrecently started now, that the industry
has become a little more cleaned up andstandardized, then okay, like that's okay.

Veljko (09:53):
Welcome to Questions in Finance,

Kate (09:56):
a podcast where we translate academic mumbo jumbo to answer
interesting questions in finance.
I'm Kate Holland.

Veljko (10:04):
And I'm Veljko Fotak.
Kate and I met when we were PhDstudents at the University of Oklahoma.

Kate (10:10):
Today we're university professors and we spend our days
teaching and researching companies,markets, and all things related.

Veljko (10:20):
Today we are asking: is short selling evil?
And as always, we start witha slight tongue in cheek.
The real more serious question is isshort selling somehow immoral, right?
And what we mean is, does itimpose externalities on society?
Does it somehow make, others worseoff, and, perhaps should it, by

(10:46):
implication, be restricted and regulated,that's, the bigger conversation.
Okay, Kate.
So perhaps we should startwith, what is short selling?

Kate (10:56):
Yeah.
And we will mostly discussequity short selling here.
So that is selling the share of acompany short, though we will touch
on a few other types of short selling,including exchange traded funds,
debt, including sovereign debt, butmostly we'll concentrate on equities.
So basically when you sell shares ofa company short, let's take Target,

(11:18):
okay, Target recently had the over 20percent decline in its share price.

Veljko (11:22):
Why are you targeting Target?

Kate (11:25):
Because Target recently had a big draw.

Veljko (11:28):
They have a Target on their back?

Kate (11:30):
They might feel targeted.
If, before their earnings release, Ilook through their numbers and went
to their stores and figured out thatthey're not doing as good as Walmart.
I could have had an expectation thattheir share price will be declining
because they are underperforming.
So then to bet on the

Veljko (11:50):
So this is a hypothetical, right?

Kate (11:52):
It's a hypothetical, but it's a convenient example to target.
Because they just did have more than20 percent decline in their stock
price, which I guess I should sayaround the 25th of November, 2024.
This is the opposite of how we thinkabout participating in company's
performance, we usually think about,okay, this company is going to do great.

(12:14):
It's share prices is going to go up.
So I buy it low and then, the shareprice is going to go from a hundred
to 150 and I make a lot of money.
This is thinking about it the other way.
It's the share price right nowis at 150, but I see the company
performance is not up to par.
And I think it's going to gofrom 150 down to a hundred.

(12:35):
So how do I participate in that tradewhere I expect the share price to decline?
Because I think performanceis going to be bad.
Do you want to talk abouthow this actually happens?
Like the details of the actual trade?
When you short the stock.

Veljko (12:52):
To recap, the company is trading at 150 dollars per
share, I have a negative outlook.
I think they're goingto decline in valuation.
So I borrow shares, that's whatstarts my short selling transaction.
You call a brokerage, a largefinancial institution or whatnot,
and you borrow shares, sell them onthe open market at today's price.

(13:14):
Presumably 150 dollars per share,and then you wait a certain period.
And let's say that you're right.
A month has elapsed.
The price per share of thiscompany has indeed declined.
It's now trading at ahundred dollars per share.
You go buy the shares on the openmarket again at a hundred dollars per
share to close your borrowed position,return the borrowed shares, right?

Kate (13:40):
Yep.

Veljko (13:41):
So you sold at 150, you repurchased at a hundred, then you made a
profit of 50 per share from this decline.
Of course, whoever lent you theshares is not doing it for free.
There is a borrowingfee that you're paying.
To be clear for most, as yousaid, we are mostly talking
about equities here, on, on U.

(14:02):
S.
markets.
Those tend to have very liquidborrowing, markets, those borrowing
fees tend to be fairly small.
Now not always, right.
There are particular instances,so called short squeezes, when the
availability of shares in the openmarket becomes lower and borrowing fees

Kate (14:20):
many people want to short the stock

Veljko (14:22):
when the demand for share really skyrockets.
But those are extreme cases.
For the most part, it isrelatively cheap to short.

Kate (14:29):
We should probably mention that this is a most typical way to
short sell a company, but, oftentimestraders also use put options.
There's a paper in the Journal ofFinancial and Quantitative Analysis,
in 2020 showing that, put option volumeis also related to short selling.

(14:49):
So a put option is a option tosell some shares of stock at
a certain price in the future.
You would be purchasing putsthinking that the price will decline.

Veljko (15:03):
You're right, Kate.
There are other ways to betagainst a company and you're right,
put options are one such way.
In some ways, I always found that,isolating or targeting short sellers,
for benefiting from the decline of acompany, seems, selective, why do we
have an issue with short selling, andnot with buyers of put options, right?

(15:27):
They all face the same set of incentives.

Kate (15:30):
I think there's an issue with both.

Veljko (15:33):
I don't hear the same level of popular opprobrium.
Think about the GameStop saga, right?
Where, the internet came out, criticizingshort sellers for profiting from
the declining valuation of GameStop.
And, I don't remember anybody singlingout, put option buyers of GameStop.

Kate (15:51):
Right, right.

Veljko (15:53):
But perhaps we'll return to GameStop later on.
We were talking about the basicdefinition of short sellings and I think
one thing that we should make clearis that it's a very risky transaction.

Kate (16:05):
There's no closing off of the prices for your trade.
The downside here iskind of flipped, right?
The stock price can keep runningagainst you into infinity.

Veljko (16:15):
What you're trying to say is that, of course once I have to
close my position, I have to buyshares at the open market, right?
And, and of course, if I'm wrong and thoseshares, instead of declining in value,
increase in value, I incur a loss, right?
So of course, in our previous example, ifthose shares, they started at 150 dollars

(16:39):
per share, if instead of declining to 100,like I'm expecting, they go up to 200.
Now I'm losing 50dollars per share, right?
If they go to 250, I'm losinga hundred dollars per share.
If they go to 300, right.
And to the extent that the price keeps

Kate (16:54):
going up and up.
That's what I meant.
There's...
the upside is, is unlimited,

Veljko (17:00):
I was just parsing out your statement for those of us whose minds
are not as fast and as far reaching.

Kate (17:07):
Oh, maybe, my statements aren't as clear today.
But what I want to mentionis, Think about it.
What do you need to know to become ashort seller for you to decide that share
prices of a company are going up or down?
You need to really evaluate the firm.
Participate in this basic stuff that weteach in our finance classes where you

(17:28):
evaluate your company at its very base,figuring out future revenues minus costs.
But there's many minute details aboutrevenues, which markets the companies
at what products they have and costs,what is their cost of goods sold?
What is their taxes?
What is their expenditures oninvestment and capital expenditures?

(17:49):
All of these minute details fall intothis valuation model, which really
boils down to how much money is thiscompany going to make after you?
Pay all of the costs that it hastranslated into today's dollars.
So it's really a lot of informationthat short sellers need to be processing
about the company to figure outthat the firm isn't doing as good

(18:13):
as everybody else thinks it's doingright now to know that the price
of this company will be declining.

Veljko (18:19):
Short sellers have a strong incentive to discover negative
information about companies.

Kate (18:25):
Let me translate it with examples to things that are more
close to heart to more people.
And I'm going to motivate my explanationby the example from GameStop.
GameStop was one of the heavilyshorted stocks, a few years ago.
And for very good reasons, becauseif you look at the business model
of GameStop, it was outdated.

(18:47):
And if you looked at their revenuesover the last few years, they were
going only one way, which is down.

Veljko (18:52):
What perhaps not everybody understands is how reliant GameStop's
revenue model was on physicaldistribution of video games.
A very large portion of their revenue camefrom, the resale market for video games.
When those were traded on CDs,DVDs, previously cartridges.
With gaming moving to an online, on thecloud and in general, download, from, from

(19:20):
online stores distribution model, thatrevenue model seriously suffered, right?

Kate (19:26):
So you're making a great point because if I gamed, which, you know, I
didn't when I was growing up, but if Idid I can see how I would be emotionally
attached to these cartridges or whatever,like things is that you have the games on.
Right.
And so if somebody would tellme, look, this is not going
to be there in the future.
My emotional connection to thatwould be shaken and I would be

(19:48):
deeply upset with that statement.
And GameStop had a lotof short positions on it.
And a lot of retail investors decidedto rally against, GameStops short
positions thinking that these shortsare making GameStop become bankrupt.
Where in reality, they were justdoing their financial analysis.

(20:08):
They were honestly telling the market,look, we think that this company doesn't
have good future prospects, but thisemotional connection of a lot of retail
investors made them support GameStopand go against these huge hedge funds.
The retail investors did runthe price of GameStop up quite
significantly, which hurt a lotof hedge funds in their positions.

Veljko (20:33):
I think it's a beautiful example of the tensions, right?
Because as we start talking aboutthe pros and the cons, if you will,
or the arguments in favor or againstshort selling, we're going to see that
this incentive to uncover negativenews is one of the big positives.
We're going to see a lot ofresearch finding that short

(20:54):
selling prevents bubbles andreduces mispricing of securities.

Kate (20:59):
Let's talk about that positive.
Obviously, there's positivesand negatives, that we'll
discuss for short selling.
I would say, let's start with thepositives just because that's where
the research findings end up pointingto and negatives are more popular and
that's what everybody knows about.
Let's talk about the positivesof short selling since we brought
up this ability for there to bebetter prices and fewer bubbles.

(21:26):
Let's mention that as the first benefit.

Veljko (21:29):
Ekkehart Boehmer and Julie Wu have a seminal paper there, but
truly there's a lot of research,that confirms these findings.
But I'm talking about a paper EkkehartBoehmer and Julie Wu published in 2012
in the Review of Financial Studies.
They effectively find that shortselling makes prices more efficient.

(21:51):
And what they really mean withthat they find that prices show
smaller deviations from fundamentalvalues and not only smaller
deviations, but faster realignment.
So they effectively find that informationand in particular negative information is
incorporated in prices in a faster manner.

(22:13):
And, if you think about how marketsfunction, we have too few voices that have
an incentive for negative news to spread.
Managers don't love to spread negativeviews about their own companies.
Even shareholders, right?
If I'm a shareholder of a company,am I really incentivized in

(22:34):
spreading my negative opinions?
Not always.
And we know that analysts and,auditors are also in many ways....
the incentives are not as cleanas honest as they should be.
And you know, they are allfed by the same companies.

Kate (22:52):
So that's a good point.
That's short sellers really bringup some of the negative information.
Obviously, nobody likes a negativeangle, but if it's truly there, it
needs to be uncovered for prices tobe more efficient and yeah, the paper
that you are mentioning is important.
There's many papers that look atindividual stocks and find this

(23:14):
relationship between the short sellingvolume and more efficient prices for
individual firms and lower performancedown the road for individual firms.
But it's not only on theindividual firm level.
David Rapache, Matthew Ringgenberg andGuofu Zhao in 2016 published a Journal of

(23:35):
Financial Economics paper, whereas theylook at like the aggregate market short
interest, so not just individual firms,and they show that this aggregate short
interest is the strongest known predictor,that's a strong statement, strongest known
predictor of the aggregate stock returns.
Meaning that when the shortinterest is high, future stock

(23:59):
returns are going to be lower.
The short sellers are usually righton average about predicting lower
performance in the future, not onlyfor individual firms, but also if you
look at the overall market as well.
It's also interesting that paper pointsout that the economic source of this
predictability from short interest ismostly coming from the cash flow channel.

(24:25):
The short interest can predictlower returns, lower stock prices
in the future because it's somehowzooms in on this sales minus
costs cashflow channel for a firm.

Veljko (24:37):
You're interpreting the fact that short selling is followed by a
decline in prices as, meaning thatshort sellers are correct in their
predictions and yet for those who arecritical of short sellers, the counter
argument could be that short sellers arecausing the decline, by targeting firms.
This is where short sellingbecomes controversial.

(24:59):
Because there is a fine line between anincentive to spread negative information
and an incentive to disseminate rumorsor false statements, what, short sellers
are sometimes accused of, of doing.
And, and we'll talk aboutthe negatives later, right.

(25:21):
But, uh, interestingly, one of thethings that you've mentioned is this idea
that short sellers spread information.
That we're kind of giving for granted, butthat might not be obvious to everybody.
It's fascinating how some of theseshort selling firms actually operate.
When you see them in action...

Kate (25:39):
Muddy Waters, one of our favorites, I'd say.
Right.

Veljko (25:42):
Correct.
Correct.
Uh, they are one of the short sellingoutfits that have specialized in
effectively uncovering dirt about firms.
And then, effectivelydisseminating research reports.
They'll send reports to the mediasaying: " we allege that firm X
and Y is doing this and that."

(26:04):
And, then disclosing, of course, thatthey actually hold the short position.
And this often becomes extremelycontroversial and sometimes
these short sellers get caughtinto extreme legal fights.
And it was interesting, earlier whenyou were describing short sellers and
you're saying, they are digging throughthe books of companies and you're right.

(26:27):
I mean, a lot of this is justa lot of forensic elbow grease.
And yet when I'm thinking of shortsellers, maybe I have more of a
romantic view, but I'm thinking of,the swashbuckling forensic investigator
traveling to remote corners of theworld to discover that the gold mine
was not real, but it was salted, right?

Kate (26:48):
Or you're talking about the electric vehicle company, that, didn't
actually have an electric truck, right?
They just created these awesome videos.
There was no actual trucks there.
Just like there's no goldmine.

Veljko (27:03):
Hey, you're right.
That's the kind of episodesthat I'm thinking of.
So what you're referringto is Nikola Trucks,

Kate (27:11):
right?

Veljko (27:12):
This is a company that, was trying to be the Tesla for 16 wheelers, right?
And in a truly depressing lack ofimagination, they called it Nikola, right?
Nikola Tesla.
So the interesting story here behindNikola Trucks is, they, at their

(27:34):
peak, in 2020, late spring, earlysummer this company reached a market
capitalization of 30 billion dollarsand at some very brief period of time,
this this electric vehicle, electric16 wheeler startup that you've never
heard of, was worth more than Ford.

(27:55):
Until sometimes around July, 2020,Heidelberg Research, which is one of these
short selling outfits, started publishingreports, alleging that the company was
lying about the state of its technology.
There was one particular video thatthe company had released, they were
filming a truck from weird angles.

(28:16):
Some people became suspiciousof these weird angles.
So they figured out the location wherethis commercial was filmed and actually
realized that it was a steep hill.
And that made them think thetruck was not running, but it
was just rolling downhill, whichmade them question the technology.
That led to them, digging into, thecompany and finally finding a couple

(28:41):
of engineer whistleblowers that claimedthat the company actually did not have
that technology that they claimed ithad and the trucks were not operational.
Heidelberg published the research,the Wall Street Journal actually
partnered with them in publishingsome investigative reports.
At first, the company pushedback and denied all of it.

(29:03):
Eventually it was found outthat Heidelberg was right.
And the company is actually still around.
Many companies don't recover from this.

Kate (29:11):
So market capitalization is a lot lower.

Veljko (29:14):
Yeah, I think it's down like 98%.
I think they went from 30 billionto, at last I checked a couple
of days ago, it was 122 million.

Kate (29:25):
Wow.
The interesting thing is that shortsellers, they do get creative in
figuring out this information.
As you mentioned, nobody wantsto disclose negative information.
And so oftentimes it's hard to find thatdirectly in the financial statements.
So, but one thing that's been shown tobe true is that behaviors end up the

(29:45):
being very consistent through time.
If you are a liar in one thing,you'll be a liar in another thing,
if you are a cheat in one thing,you'll be a cheat in another thing.
Muddy Waters use this basically idea,to, look up , educational records
of CEOs of multiple companies to seewhether everything was correctly stated.

(30:07):
So they identified CEOs who liedabout their educational achievements
and, published that data.

Veljko (30:16):
I vaguely remember that story, and it was some stupidly
high proportion of CEOs, right?
I think they were looking at fortune500 companies and something like
20 percent of the CEOs on this listwere lying about their educational
credentials in some way, shape or form.

Kate (30:32):
On the one hand you can say, now they are the CEO of this company
and they're making me a ton of money.
But what they ended up discovering, ifthe CEO's lied about their educational
achievement, then this company hada lot of skeletons in their closet.
They had option backdating, theyhad more accounting restatements.
They had more off balancesheet liabilities.

(30:53):
And all of these things startedcoming out that were nicely hidden.
So this wasn't the only incidents ofmisstatement or fraud that the CEOs
have undertaken . And so that was away to look into the information that
they didn't want to disclose thisnegative information and glean it
from this consistent lying behavior.

Veljko (31:14):
Absolutely.
And I will also say, before wereturn to academic research, I admire
these short sellers, these outfits.
It takes a lot of guts to be contrarians,nobody thanks you for it, in many ways.

Kate (31:28):
You are disliked and people think that you are, the bad guys making
all the companies fall apart whereyou're not really the big, bad guy.
You're a small company who'sactually taking positions against
a lot of institutional investors.

Veljko (31:42):
One of the things that we haven't mentioned is, short selling
in Europe is a lot more vilifiedthan it is in the United States.

Kate (31:50):
Tell me, I would like to hear.

Veljko (31:53):
European finance has always been a little bit more gentile
and a little bit more cooperative.
The hostile M&As, were always seen as,you know, that's what American Cowboys do.

Kate (32:06):
Totally see that.
You mentioned one more reallyinteresting instance related to Europe.

Veljko (32:11):
Wirecard was a big payment processor, right?
What made this story particularlycontroversial is that Wirecard was
one of the very rare success storiesin Europe, in the tech sector.
Europe hasn't created the techgiants that the United States did.
And, Wirecard was one of thefew exceptions at some point.

(32:35):
And even there, it was arelatively weak success story.
Because effectively Wirecard was a paymentprocessor that was wading everywhere
Visa and MasterCard didn't want to touch.
They were working with a lot ofcannabis dispensaries, pornography
websites, they were working in partsof the world where Visa and Mastercard

(32:56):
didn't really want to step in.

Kate (32:57):
Sin businesses.

Veljko (33:00):
Correct.
And, the interesting thing is, foralmost a decade, starting as early
as the mid 2000s, short sellers andjournalists have been alleging that
Wirecard, that there was somethingfishy in their business model.
And that simply some of thereported numbers just didn't add up.
And, early on, there wereallegations that their actually

(33:23):
Asian businesses were growing wayfaster than kind of made sense.
The interesting thing is that asearly as 2014, actually, a journalist
from the Financial Times, Dan McCrumstarts writing negative stories about
accounting in Wirecard after receivingtips from John Hampton, who's, also

(33:46):
a famous short seller, I think he'sAustralian, if I remember correctly.
And, Wirecard immediatelypushes back very strongly.
To the point that they actuallyrun to the Germans, Federal
Financial Supervisory Authority.
This is the Security andExchange Commission of Germany.
The German authorities react first bybanning short selling of Wirecard, right?

(34:10):
And forcing actually existing shortsellers to close positions, right?
And then actually openinginvestigations first after.
against the Financial Times, allegingthat the Financial Times was manipulating
markets, and then specifically againstDan McCrum and, Stefania Palma,
who was actually another FinancialTimes journalist working in their

(34:33):
Singaporean office and investigatingwhat's happening in Singapore.

Kate (34:38):
Imagine being Wirecard at that time.
You're an executive and Wirecard,you know, what these journalists
have revealed is indeed true.
And then you choose to fight againstit to say that, oh, this is not true.
We're not like that.

Veljko (34:53):
Oh, it's actually fascinating to look at, you know,
these CEOs were totally outraged.
And again, there is a huge degreeof nationalism here, right?
Because, as you can imagine, theseare, German champions of the German
industry in front of German regulators,in front of the German press, talking
about the short sellers coming fromthe UK, from the United States,

(35:16):
from Australia, alleging fraud.
There are very strongnationalistic undertones here
in, in this whole conversation.
But the point is for almost fouryears, these German financial services
authorities keeps investigating, draggingthese journalists in and out of court.
Fining the Financial Times, and theFinancial Times ends up appealing it.
In the meantime, , under moreand more scrutiny, Wirecard

(35:39):
ends up hiring a new auditor.
And then this auditorcannot find evidence of 2.
6 billion cash account, that Wirecardalleges or had alleged all along to
have, and this leads them to unravel.
And eventually they admit that,yeah, David McCrum, the short

(36:00):
sellers were right all along.
But you go from being, a villainaccused of manipulation to being
the hero that uncovers fraud.

Kate (36:10):
Very interesting, fascinating story, but as we said, on
average short sellers are right.
But I was thinking as you were sayingthat, what could have Wirecard done
if these allegations were not true?
If for some reason this DanMcCrum was actually spinning
a story that wasn't true.
There is a paper by Leonce Bargeron,and Alice Bonaime it's a Journal

(36:35):
of Financial and QuantitativeAnalysis, in 2020 where they address
hypothetically, what if this Dan guywas not telling the truth about them?
What Leon's and Alice show is that,companies that disagree with a short
seller statement, they actuallyend up buying their own stock

(36:57):
or repurchasing their own stock.
And their executives alsopurchase additional shares.
So basically what they'resaying is there's some negative
information coming out about us.
We're just gonna buy more of our stockbecause we think it's undervalued
we see our current projects andwe know there's awesome projects
that we have under the covers.

(37:19):
Leonce and Alice end up showingthat these purchases appear to be
motivated by some private informationof managers because future earnings
do end up being more positive.
So, what can you do if you want to signalthat short sellers are not correct?
You're just gonna keep performingawesomely into the future.

(37:42):
Keep, producing good products,blowing out earnings expectations
and having higher revenue projectionsand repurchasing some shares.
On average, short sellers arecorrect, but there are some instances
where they're not, how can firmspush back against short sellers?
They can keep performing well.
And they can repurchase their stock.

Veljko (38:03):
It's interesting if you're an external observer of this
battle, how do you read into that?
How do you interpret thissignal from the outside?
You have all this literature tellingyou that short sellers trade when
they're informed, we haven't made thisexplicit, but it's because there are
these huge risks that they're taking isbecause they're paying borrowing fees.
So they only trade when they havea certain degree of confidence.

(38:26):
That's why on average, whenthey trade, they're right.
On the other side, you have thisliterature saying that managers, when
they trade out of their own pockets,their own stock, they're usually right.
They're not supposed tohave inside information and
yet, we know that, they do.
It almost feels like, when you havethe unstoppable object meeting the

(38:47):
immovable object, what happens?
You have these two forces clashingthe informed short sellers
and the informed managers.
And yet, I don't think that as amanager you can increase the value
of your shares by repurchasingthem, I don't think this is causal,

Kate (39:04):
no, they are repurchasing them because if the prices have gone
down a bit, they think that thisis a good opportunity, basically.

Veljko (39:11):
They repurchase them because
they know that they're undervalued.
Yes.
Absolutely.

Kate (39:14):
As you said, Europe has a lot of objections.
Too short selling more sothan the United States.
And, yeah, I want you tomention one more objections that
Europe has to short selling.
That's even more interesting.

Veljko (39:28):
One of the arguments against the ethics of short selling is statements
coming from the Pope, the statementcoming from the Vatican, right?

Kate (39:38):
Right.

Veljko (39:39):
And, in some sense it almost feels like...
why are we even talking about this?
Because the Pope has spoken.
The Vatican, the Pope has spoken.
The Vatican has said what they think.
They say short selling is immoral.
They say short selling shouldn't be done.
And it's like, well, game over, right?

Kate (39:59):
I think they received some really good educated replies.
to their statements.
And I think, I hope that they'veadjusted their statements
after reading those replies.

Veljko (40:09):
Actually, no, this is interesting.
No, they haven't, by the way.

Kate (40:13):
So tell us a story.
Tell us a story.

Veljko (40:15):
What you're talking about is, a bit of a back and forth
between the Vatican and Americanregulators started in, May 2018.
It was May 17th, 2018 when the Vaticanactually published, a bulletin, these
are official proclamations of doctrineof the Vatican, which, if you're

(40:37):
Catholic, mean truly a lot, this bulletinpublished on May 17th, 2018 is titled
Aeconomicae et Pecuniarie Questiones,or, Questions about Economy and Money.
In English it was translated intoConsiderations for an Ethical
Discernment Regarding some Aspects ofthe Present Economic Financial Systems.

Kate (41:00):
Wow.
A lot longer.

Veljko (41:02):
Seems like a bit of liberty in how they took that.
But, this was pretty interesting.
The Vatican actually, issuing theseextremely strong statements against modern
financial markets, in which in particularthey were singling out as immoral actions
that and here is their language "actionsthat permit gambling at the risk of the

(41:28):
bankruptcy of a third party or actionsthat create a unique case in which persons
start to nurture interests for the ruinof other economic entities and shapes an
event of a kind of economic cannibalism."
it's really a bit of a convolutedstatement, but effectively, the relevant

(41:49):
part here is they're saying that, it'simmoral to engage in any contract that
permits gambling, and creates a casein which you nurture an interest in
the ruin of other economic entities.

Kate (42:05):
Oftentimes you are not nurturing this interest.
Is that is already there.
You're just disclosing theinformation and actually allowing
for more efficient prices.

Veljko (42:14):
No, but, but what they mean with nurturing an interest,
they mean carrying an interest,in other words, profiting, right?

Kate (42:22):
Oh, I see.

Veljko (42:23):
They're effectively saying that having an exposure to a profit
that emerges from the ruin ofothers is automatically immoral.

Kate (42:31):
But it's, it's okay if you're profiting from when prices go up.

Veljko (42:34):
So, no, they don't say anything about prices going up.
They're singling out as immortal the actof profiting from ruin that's immortal.
Now the language actually gets morespecific later on and here is where
I think it gets really interesting.
They reserve special reproach forwhat they describe as naked purchases
of protection on sovereign nations.

(42:58):
Just to finish the position of theVatican, they single out gambling
that a nation will default.
And then they actually specify thatsuch purchases are considered quote
unquote extremely immoral actionsand specifically because they benefit
from "enormous damage for entirenations and a million families."

(43:19):
Effectively they're saying, it'sthe fact that you're profiting from
the misfortune of a large numberof people of entire nations that
makes it particularly distasteful.
And then finally, they actuallysay that this calls for sanctions
of maximum severity, which I mean,that's kind of scary when it's
coming from the Vatican, right?

Kate (43:38):
What are sanctions of
maximum severity from the Vatican?

Veljko (43:42):
They don't say.
This is from an institutionthat, you know, this ranges
from inquisition level torture.

Kate (43:49):
Well, I don't think that's implemented
anymore.
So what's the worst in the current days.

Veljko (43:54):
Eternal damnation?

Kate (43:56):
What about something a bit more tangible than eternal damnation?
Is there something more tangible?

Veljko (44:01):
I don't know.
Did you read Dante?
I mean, some of those circlesof hell are pretty tangible.

Kate (44:08):
No, no, I mean like in inquisition you lose your head.
Very tangible.
But this internal damnation,you know, it's very intangible.
So like, what is the mosttangible sanction, I guess, right?

Veljko (44:18):
Again, Kate, Christmas is approaching.
I'm going to be glad to giftyou a copy of Dante's Inferno.

Kate (44:25):
This does not solve the intangible tangible issue.
I want to see what is the mosttangible sanction imposed.

Veljko (44:32):
I'm not going to talk about torture and all the kinky stuff that
happens in hell in Dante, but, to goback to our point, people that took
the proclamations of the Vatican alittle bit more seriously than your
heretical self were actually thepeople at the head of the Commodities

(44:54):
and Futures Trading Commission.

Kate (44:55):
I see where the statement is coming from, but I think
it misses the full picture.
It only is capturing a verysmall piece of the picture.
And as we know, the road to hellis laid out with good intentions.
So I think this is a perfect exampleof that statement because as they
are pointing out one issue, but whatthey're, Not realizing is if short

(45:19):
selling of the sovereign nationsgoes away, these nations will never
have access to debt that's basicallycheap enough for them to live on.

Veljko (45:29):
You're absolutely right.
I think this is a fascinating story,like a fascinating anecdote and it gets
better when you start reading that,shortly afterwards, as we were saying, the
Commodities and Futures Trading Commissionissued a very strong reply to the Vatican.
And this was actually ChristopherGiancarlo, the Chairman of the

(45:52):
CFTC and Bruce Tuckman, the ChiefEconomist of the Commodities
and Futures Trading Commission.
Right.
And to be clear, the CFTC, theyregulate a lot of the derivatives
markets of complex financial instruments.
And the Bollettino was also singling,when they were talking about these
naked protections, credit derivativespreads, CDS contracts, right?

(46:16):
So, on July 21st, 2018, the Chairman andChief Economist of the CFTC co signed
a letter in reply to this Bollettino.
And I just love how it starts, right?
I hope you won't mind if I just readthe beginning of it, but it starts

with (46:33):
"Your Eminences, the Congregation for the Doctrine of the Faith," the
official name of the Vatican's Holy Screethat issues these documents, "recently
published the above reference bulletinon economic and financial issues.
Building on the premise that no areaof human action is outside ethical
principles, the document lays outethical foundations to govern economic

(46:56):
and financial systems, includingin the usage of derivatives."
And then they say, "We thank you for sucha thought provoking reflection" and then
they just go on in 20 pages of schoolingthe Vatican on how financial markets work
and, why these are important instruments.
I love some of thearguments that they make.

(47:17):
They're really talking about howthese instruments and how short
selling allows farmers to protectthemselves from downside risk,
which allows them to provide foodfor the world at lower prices.

Kate (47:30):
Right.

Veljko (47:31):
And anybody interested in the arguments in favor of financial
markets contributing to society.
And again, it is a twosided argument, right?
I mean, it's not that I don't see thecounter argument or the downside, but yet
these guys make a very cogent, extremelywell articulated argument for the social

(47:54):
utility of derivative markets and ofshort selling, I invite anybody interested
in this topic to really read it.
I haven't found any indication of theVatican responding to this document.
But, shortly afterwards, theVatican announced that they were
banning short selling for anyof their own investment funds.

Kate (48:14):
So Vatican has an investment fund.

Veljko (48:16):
The Vatican's bank actually has, one of the oldest, largest, investment
vehicles operating in Europe, it's aninstitution that was mired in all sorts
of scandals, the heads of the VaticanBank tend to die violent deaths, right?
And there were some reallyfascinating stories about that.

Kate (48:32):
I'm thinking about all of this, what we've talked about, GameStop,
Vatican and this general perceptionout there that, short sellers are
bad, which we don't see empirically.
We see empirically, with research thatthey indeed correctly predict worse
performance of different companies.

(48:53):
They make prices more efficient,but overall, why is there
this negative perception?
I think it comes back to a veryemotional perspective, back
to your video games, right?
It's kind of like people whoare missing those cartridges.
I think people think about shortselling and they can even turn
it into personal examples.
So of course that elicitsnegative emotional responses.

(49:16):
So I think that, GameStop and thisresponse from the Pope and this general
feeling that short selling is not good.

Veljko (49:23):
In some ways you are going back to the eternal debate of are short sellers
correctly predicting a price decline thatwould have happened anyhow, and perhaps,
accelerated it, and in a Schumpeteriansense of the world helped redeploying
assets to a more efficient use, right?
Which I guess is the interpretation thatmost of the literature finds towards it.

(49:46):
Or are they on the other side causingthe decline which is what at least
some people are accusing them of doing.
Most of the evidence, In theliterature seems to be on the former
rather than the latter, right?
But then again, averages don'tnecessarily tell the full story, right?
But I think there's an interestingpaper by Asher Curtis and Neil Fargher.

(50:08):
This was published inManagement Science in 2014.
The paper's title tells the whole story.
"Does Short Selling AmplifyPrice Declines or Align Stocks
with Their Fundamental Values?"
I love this paper because they're reallygetting to the fundamental question here
of, is short selling correctly leadingto a decline in overvalued securities,

(50:32):
or is it actually causing declines insecurities that are targeted, right?
And I'll quote here, their abstract.
They start with "critics of shortselling argue that short sellers amplify
price declines by targeting firms withfalling prices in an unwarranted manner.
Contrary to this viewpoint, we findthat increases in short interest for

(50:53):
firms following a price decline areassociated with measures of overpricing
based on financial statements analysis."
So they're saying that you can see in thebalance sheets and income statements of
these companies, evidence of deterioratingperformance that short sellers are.
Capable of spotting andidentifying perhaps faster

(51:14):
than other market participants.
When we talk about how shortsellers help incorporate negative
information in prices faster.
There are two distinct mechanisms,one of those is the direct
action of trading, right.
By borrowing shares and then sellingthem on the open market, you're
increasing supply of shares and anincrease in supply, all is equal,

(51:38):
leads to a decline in prices.
And yet this mechanical effect isprobably even less important than,
as we said earlier, this incentiveto dig out, uncover, and disseminate
negative information, right?
But as we were saying aboutpricing efficiency, right?
I think it's also important to link thisidea that it's not just these mechanical

(52:01):
pressures are going to lead to a betterpricing of individual securities.
There's a lot of evidence out there thatshort selling will lead to fewer bubbles.
And there were actually variouspapers looking at restrictions on
short selling around the world andactually finding that effectively

(52:22):
when you have, more short selling orwhen you allow more short selling,
your, economic cycles effectively.
weaker, they smooth out, right?
In other words, what we're talkingabout here is pretty much every
economy around the world seems to goover a periodic boom and bust cycle.
And it is this eternal debate of why dowe have these periodic bubbles, right?

(52:46):
And one of the reasons is because, ofrestrictions on short selling right?
And if you think about it, there'ssomething interesting that we didn't quite
talk about In the price discovery process.
Financial researchers, especiallythose crazy people in asset pricing,
they're a lot smarter than us lowlycorporate finance people, right?
They tell us that prices are,indicative of the prevailing

(53:10):
opinions in the market, right?
But the reality is that anybody whothinks a stock is undervalued, can buy it.
Which effectively pushes, thisdesire to buy something, this
demand will push the stock price up.
And yet, only the people who alreadyown a security can sell that security

(53:32):
if they think it's overvalued.

Kate (53:34):
Well say you can sell it short Right.

Veljko (53:36):
In the absence of short selling.
That is right.

Kate (53:39):
Oh, in the absence of short selling.

Veljko (53:40):
That's, that's what I'm trying to say.
That's why short selling issuch an important mechanism.
And I think that gets lost a littlebit in all these conversations.
The fact that you have thisasymmetry in the absence of short
selling, which pushes share pricesup constantly and leads to bubbles.
Short selling helps mitigate that.

(54:01):
That's really one of the bigbenefits of short selling.
Now, when it comes to bubblesand short selling, theoretical
literature is extremely clear, inits predictions and there are various
models here, but effectively, Imean, the intuition is pretty simple.
By helping to incorporate negativeinformation in a more efficient

(54:23):
and faster manner, short sellingreduces the possibility of a security
becoming overpriced and hence itreduces the likelihood of a bubble.
So fewer bubbles forming equalsfewer stock price crashes and
especially at a market wide level.
So, for example, there isa paper published By Jose

(54:46):
Scheinkman and Wei Xiong.
And this is in the Journal ofPolitical Economy, published in 2003.
And the title is "Overconfidenceand Speculative Bubbles."
It's a theoretical paper that showsthat asset price bubbles happen because

(55:06):
of a combination of two factors,overconfidence by at least some traders
and constraints on short selling thatprevent other more rational traders from
arbitraging this overconfidence away.
And as I said, this is just onepaper, probably the most cited,

(55:26):
in this theoretical space.
But for example, there isanother paper published in
2006 in the Journal of Finance.
This is by Ernan Haruvy and CharlesNoussair, and the title here, "The Effect
of Short Selling on Bubbles and Crashesin Experimental Spot Asset Markets."
The conclusions are similar.
You ban short selling, you getmore bubbles, and after more

(55:49):
bubbles, you get more crashes.
Now, while the theoretical literatureis very, very clear here, there is at
least some degree of disagreement inthe empirical literature, whether these
theories actually translate on the ground.
There is one very highlycited paper on the yes side.
This is, Arturo Bris, William Goetzmann,and Ning Zhu, in 2007, published a

(56:15):
paper titled "Efficiency and the Bear.
Short Sales and Markets Around the World."
This paper effectively looks at 46equity markets around the world and they
look at restrictions on short selling.
And what they actually find is thatmarkets in which short sales are subject
to greater degrees of restrictionsor are outright band suffer from a

(56:38):
greater chance of bubbles forming andsubsequently more stock price crashes
after these bubbles finally deflate.
Well, I guess I I'll mention anotherpaper that does find that short sales
reduce the likelihood of bubbles.
This is Stefan Nagel, in the Journalof Financial Economics, in 2005.

(56:59):
"Short Sales, Institutional Investors,and the Cross Section of Stock
Returns," where he effectively findsthat in the presence of short sales
stocks are less overvalued and theydeviate less from fundamental prices.
Which again, it's not directlyaddressing bubbles, but it's finding
evidence, very consistent with theidea that you allow short selling,

(57:22):
you get less, less overpricing, butas I was saying, not everybody agrees.
There is, for example, work by RobertBattalio and Paul Schultz, published
in the Journal of Finance in 2006,paper titled "Options and the Bubble."
And they actually ask whether shortselling actually had any role in

(57:45):
reducing overpricing of internetsecurities during the dot com bubble,
late nineties, early two thousands,and they actually answer negatively.
They actually conclude that shortsales did not help keep prices in line
during, during that particular bubble.
In all defense for the argument pro shortsales in this context, I think that, you

(58:11):
know, looking at one particular episodein which there are already some degree
of constraints of short on short sales,and then concluding, short sales are
not, you know, helpful , in reducingbubbles, that seems a little bit unfair.
And, and I'm in their defense Idon't think that Battalio and Schultz
originally meant it that way, butI know that that paper is cited at

(58:31):
times as evidence against this ideathat short sales help, reduce bubbles.
And I'm not entirely sure that'swhat I would take away from it.
So from a theoretical standpoint,the predictions are clear.
Short sales should reduce bubblesfrom an empirical standpoint.
The evidence is a little bitmurkier and yet you're not studying

(58:55):
unconstrained short sales, right?
Every time you're studying shortsales in the real world, there are...
I mean, every regime, everycountry, pretty much restricts
short selling to some extent.
So you're always looking at whatimpact does constrained short
selling have on market quality.

Kate (59:13):
I think there's another way through which selling works, not only
is this mechanical more shares or, youknow, we've uncovered more information.
It also makes prices moreefficient because of fear.
It's a disciplining mechanism after all.
Because short selling exists, it bringsin the discipline to where managers and

(59:37):
executives end up behaving better as well.
What do I mean here?
They're more honest in their earnings.
They're less likely to manage earnings.
And there's actually twopapers that discuss that.
There's a Vivian Fang, Allen Huang, andJonathan Karpoff, 2016 Journal of Finance.
Jonathan Karpoff has been known towork in the fraud literature a lot.

(01:00:01):
He's written a lot of papers on fraudand basically their paper saying that,
short selling, helps detect fraudand it also curbs fraudulent activity
through the disciplining mechanism.
And another paper is MassimoMassa, Bohui Zhang, and Hong Zhang,
2015 Review of Financial Studies.

(01:00:22):
So just, it's slightly before the firstpaper I discussed and they basically
reach a very similar, conclusion.
It's just that these two papersexamined two different time periods.
The Massimo Massa paper examines2002 through 2009 time period.
Johnson Karpov's paper examinesthe 2005 through 2007, SEC, pilot

(01:00:45):
program for Russell 3000 index stocks.
It's also has this additional angleof being a disciplining mechanism.

Veljko (01:00:53):
Yeah.
So, this is, I would say adistinct benefit of short selling.
Number one, short sellersimprove price efficiency.
With better price efficiency,you get fewer bubbles.
Now what you're talking aboutis this other benefit of short
selling, which is effectively animproved governance mechanism.
And yes, I fully agree.
Once managers know that somebody hasan incentive to uncover bad behavior,

(01:01:22):
incentives to misbehave decline.
They should behave ina more honest manner.
Yes.
And these papers, they mostly use,earnings, restatements, right?
If afterwards the firmhas to restate earnings

Kate (01:01:33):
there was some funky business happening in the first place there.
They were misstating them.

Veljko (01:01:38):
Correct.
You're absolutely right.
Now, we know that pricing effects areone of the benefits of short selling.
We spoke about the governance incentivesand how short selling leads to

Kate (01:01:50):
discipline.

Veljko (01:01:51):
Yes.
Managerial discipline.
What we haven't spoken about isperhaps the less sexy, but actually
probably most important part of thisliterature that looks at the market.

Kate (01:02:04):
Microstructure.
You're going to start talking aboutbid-ask spreads and all that and
dealers managing their inventories.
I'm already a bit bored, but I agree.
This is a very important aspect.
So yes, let's talk about this paperby Jonathan Brogaard, Terrence
Hendershott, and Ryan Riordan,Journal of Financial Economics.

Veljko (01:02:26):
How, how, how could we not after such enthusiasm, right?
So market microstructure is a branchof, of course, the Finance literature
that if you're not a researcher,you might be less familiar with.
It's a part of Finance that deals withhow the plumbing of markets works.

(01:02:48):
How do markets clear?
How are auctions designed?
How do trades happen?
And, short sales and high frequencytrading are two very big topics in
the market microstructure literature.
So here you're catching a paperthat sits at the intersection
of these two huge topics.
Broggard, Hendershott, and Riordan,it's a paper on high frequency

(01:03:10):
trading and the 2008 short sale ban.
They find evidence that short sellingallows liquidity providers to hedge or
to manage, if you will, inventory risk.
The whole point is, when you want totrade, when you want to buy or sell
a security, the average, person,trader, investors, will contact

(01:03:31):
a financial institution, right?
And this financial institutionwill Be ready to buy or sell.
The fact that they're ready to buyor sell when you want to trade, is
what we in finance call providingliquidity, so providing others, the
ability to trade a security, right?
And what we need to understandhere is that in order to trade

(01:03:52):
securities, these financialinstitutions have to carry inventory.
If somebody wants to buy shares of Apple,the financial institution has to have
shares of Apple on their inventory, right?
And the act of carryinginventory is expensive.
Inventory needs to be financed, but moreimportantly, inventory carries a risk.

(01:04:13):
If I carry shares of Apple in myinventory, there is a risk that these
shares will decline in value and thatwill hurt me, Financial institutions want
compensation for the cost of financingtheir inventory, and compensation
for the risk of carrying inventory.
Now where this becomes relevant isthat short selling, by allowing you

(01:04:34):
to bet on a decline of the value offinancial security, can allow you to
effectively hedge, a long position.
In other words, if you hold shares ofApple, you can short sell shares of
Apple, and now you are hedged in thesense you're neutral in terms of whatever

(01:04:56):
happens to shares of this company.
So what Broggard, Hendershott, andRiordan are effectively saying is
that these financial institutions,when they're allowed to short sell,
can manage their inventory riskmore easily, which allows them to
provide liquidity at a cheaper rate.
What that effectively means for all ofus is that we can trade faster, that our

(01:05:20):
trading orders are executed faster becauseinstitutions have larger inventories, and
that we can trade with cheaper expenses.

Kate (01:05:27):
So what they actually do later is that they split high frequency traders,
which are not going to be people.
These are computers and non high frequencytraders, which are people like me and you.
So what they show is that non highfrequency traders, which is people, their

(01:05:48):
short selling indeed improves liquidity.
But if high frequency traders, AKAcomputers are trading, the short sales
associated with high frequency tradingis actually harmful to liquidity.

Veljko (01:06:06):
Yeah, I love that, right?
Because I think in all theseconversations about means, we
lose sight of the nuances, right?
And I think it's important to say thatall of the papers we've cited so far
are going to find that on an average,short selling has positive effects.
But that's not to say that there are nocorner cases, or anecdotes of malfeasance.

(01:06:33):
And yet, digging in these papers,we haven't really found much of it.
And I will say, we haveour own work, right?

Kate (01:06:42):
Please.
Tell us about your paper.
That will be interesting to hear.

Veljko (01:06:46):
We have a paper, published in the journal of Financial Economics in 2014.
And with we, I mean, Vikas Raman,Pradeep Yadav, and of course, myself,
where we actually look at the impact ofnaked short selling on market quality.
Naked short selling is short sellingwithout pre borrowing, right?

Kate (01:07:08):
So how, how did you get interested in that question?
And what did you expect to findbefore you went into the paper?
What attracted you to that?
What's so interesting about it?

Veljko (01:07:21):
No, I love the question.
And you're absolutely right to be askingthis, because, we were thinking that if
there is any corner of the short sellingmarket that is dubious and possibly has
negative consequences on market quality,in a systemic manner, this would be it.
So we actually started writing this paperwith the intention of finding evidence

(01:07:43):
of fraud, malfeasance, manipulation,if you will, through naked shorting.
Ultimately we found exactly the opposite.
We ended up writing this paper andconcluding that, even naked short selling,
was actually leading to improvements inmarket quality, especially through this
liquidity improvement channel, becauseit was allowing liquidity providers to

(01:08:08):
manage inventory in a better manner.

Kate (01:08:10):
Interesting.
So you went then actually thinkingthat you are going to find
evidence that short selling is bad.
That was your initial conjectureabout the results, but actually when
you looked at the data, you foundsomething completely opposite, that
short selling, even naked short sellingwas still beneficial on average.

Veljko (01:08:32):
It did surprise us.
It really did.
And, you know, it feels like true sciencein action, or at least it did to me.
So many times we start studieswith a strong suspicion of
what we are going to find.
And then we confirm ourexisting knowledge and certainly
there's satisfaction in that.
And yet, starting with a hypothesis ofhow this works and finding through, years

(01:09:01):
of work, frankly, that this hypothesiswas wrong, leading us back to the table
to studying the process more, developing abetter understanding, developing a new set
of hypotheses, running new studies, andeventually finding that, yes, indeed, our
original preconceived notions were wrong.

(01:09:21):
And this actually has a positiveimpact on market quality....
it felt good.
But the interesting thing is that,there was an extreme amount of pushback.
We published this shortly after the globalfinancial crisis, and I guess, defending
short sellers after a financial crisisis never going to be a popular opinion.
Now, we never finished explaining hownaked short selling even works, right?

(01:09:45):
In case somebody's still out therewondering, how can you sell a share
that you haven't even borrowedand that you obviously do not own?
The whole catch relies on the factthat at the time of us writing, most
US securities were settling on a Tplus three delivery system, which means
you had three days to deliver a share.
This was 2014, 15, when we publishedthis paper and we had regulation that was

(01:10:11):
aiming at changing delivery systems, butit's interesting that even then, right,
you live in this modern electronic world.
And yet, you still have threedays to deliver shares like, you
know, like they are traveling bycarrion pigeon, across the country.
But even in this corner of the market,we were finding these positive, impacts
in terms of liquidity and marketefficiency connected to even this

(01:10:34):
more extreme form of short selling.
And effectively, what we werefinding in our paper is that most
of it was coming from, financialintermediaries who were just not
managing their inventory properly.
You have multiple traders across multipledesks, two of them get phone calls at the
same moment for the same Apple shares,one of them sells the shares that exist,

(01:10:55):
the second one sells the same shares.
Technically now they're naked.
And, this is not what, when peopleare thinking of the predatory
naked short seller thinking of,the guy manipulating the supply of
shares, trying to distort markets.
We were actually finding that thatwas extremely rare because it's risky

(01:11:16):
and because it's costly and becauseultimately clearing houses will not...
There's this fundamental misunderstandingin markets that, if you fail to deliver
shares, you can somehow profit fromit, that many critics of short selling,
allege, and the reality is that,usually, until the short sale is closed,

(01:11:39):
there's a cleaning house that keeps thefunds until you've settled everything.
So this idea that you can, somehowsell shares, pocket proceeds, and
then just walk away and disappear,is just not born in reality.
And that's one of the things thatwe were finding in our paper.

Kate (01:11:56):
What I still find most fascinating about your story is that you went in
thinking that you'll find that nakedshort selling has a negative outcome.
It's viewed from a negative lens, soto say, so that was your expectation.
But what you actually find is that eventhough it's naked short selling, it still

(01:12:16):
provides improvements in market quality.
So it allows for prices tobe more efficient and to
better reflect information.

Veljko (01:12:25):
Yes, absolutely.

Kate (01:12:26):
Yeah.
So, I feel like, we've provided a lotof examples in our discussion today
of these expectations of negativityassociated with short selling.
We linked it to the GameStop example,to what the Pope has said, to this
emotional connections that people mighthave . But then when we backtracked

(01:12:47):
and brought in academic research, whatit's showing is that a lot of this
emotional reaction doesn't actuallyhave any basis in actual data.
What we see is that short sellingbrings about a lot of benefits.
It makes prices more efficient.
Short sellers are on average also correctabout the information that they disclose.

(01:13:10):
So they do find that the companyisn't doing good and they see ahead of
the overall market because firms andmarkets with more short positions end up
experiencing lower stock returns later.
So it seems like empirically and thedata tells us that short selling really
is a force for the good, whereas aperception out there is sometimes that

(01:13:35):
short selling is a force for evil.
This addresses our main goal of thepodcast, where we wanted to bring
in topics that have one perceptionout there in the public, but if
you look into the data, you findactually a conflicting result.
So here we're saying, short selling bringsin a lot of important information and
some perceptions about it are not correct.

Veljko (01:13:57):
Yeah, and you're right.
And yet we probably should mention,there are some academic voices
that are critical of short selling.
Markus Brunnermeier and MartinOehmke have a paper in the Review
of Finance published in 2013.
By the way, Review of Finance, right?
the European of journals.

(01:14:19):
And again, I think there is a biashere, when Europeans are looking at
short selling versus Americans I mean,we all try to be scientists, right?
And yet perhaps we editorialize.

Kate (01:14:28):
Well, you know, the paper we're talking about by Marcus
Brunenmeyer is a theoretical paper.

Veljko (01:14:35):
The paper itself, has an ominous title, right?
Predatory short selling.
And it actually focuses on financialinstitutions in particular.
And the story here, looks at thefact that financial institutions
often have debt with covenants.
These covenants are effectivelycontractual clauses that require

(01:14:57):
financial institutions to maintain acertain ratio of debt to equity values.
And the idea here is that short sellersby inflating supply of shares can
drop the value of equity to the pointthat they trigger covenant violations
and in that way end up damagingcompanies and this damage then ends

(01:15:17):
up being profitable for short sellers.

Kate (01:15:19):
It sounds like a plausible story.

Veljko (01:15:22):
Absolutely.
And I think that your commentis a loaded comment, right?
I mean, I can hear theobjection in your voice.

Kate (01:15:29):
Well, I mean, empirically this theory isn't supported, but
I'm going to highlight again, onaverage, I bet that their story might
be true for like one or two, in oneor two instances, somewhere there.

Veljko (01:15:42):
The point being, it's a very plausible story, right?
And we all know that there are veryplausible stories against short selling,
and yet the empirical evidence is scant.
Now, one of the series of papersthat I actually do find have slightly
more meat to them when criticizingshort selling is actually work

(01:16:02):
by Henry Hu and Bernard Black.
This is actually work that mostly came outin law journals, not finance publications.
They actually talk about empty voting.
And you're the expert onshareholder meetings, Kate.
So, empty voting, the whole idea herebeing that when shareholders in a company
have, isolated voting rights from cashflowrights, they can engage in shenanigans.

(01:16:29):
So in other words, if I own shares in acompany, I get to vote on the shares and
with those votes, I can make decisionson behalf of the company or force the
company to make certain decisions.
And if I don't own cashflow rightsin the company, I can effectively
strip this company of its assets,transfer those assets over to myself

(01:16:53):
or to some other companies that I own,without incurring any economic damage.
So the typical example of thisis in the context of a merger.
Say I'm a shareholder of companyA, company A bids for company B.
I buy shares of company B.
And then I short shares of company B.
And there are some inefficiencies inthe transfer of voting rights here

(01:17:16):
that they document, which leads to,effectively, now I can vote for company
B without having any economic exposure.
So when company A makes a mergeroffer for company B, I vote
for a very low share price.
As a shareholder of company B, Isuffer, but my shares are hedged.

(01:17:38):
I'm short, right?
So I don't take an economic hiton that side as a shareholder of
company A, I profit and walk away,having bought assets, having bought
company B for below market value.
They had a series of paperswhere they were identifying
instances of likely fraudulentbehavior around shareholder votes.

(01:17:59):
And they were showing that theseinstances of fishy behavior around
shareholder votes were often correlatedwith high volumes of short selling.
Suggesting that short selling wasenabling, this kind of negative behavior.

Kate (01:18:13):
Oh, enabling that negative behavior?

Veljko (01:18:16):
Yeah.
The idea that, by allowing you to hedgeyour position and separating cash flow
rights from voting rights, now you havea way of stripping companies of assets.
So short selling is effectively allowingyou to create that wedge between cash
flow rights and control rights thatallows the stripping of company assets.

(01:18:41):
You still look skeptical,which part of this?

Kate (01:18:44):
Empty voting is a truly interesting story.
I'm just more interested inmore straightforward stuff.
I'm interested in the empiricalresults shows a short selling
helps price discovery.
And that's what I was concentrating onand the empty voting, super interesting
story, but just felt like it's alittle bit outside of that main domain.

Veljko (01:19:05):
I think that the scales here are tipping very heavily on one side.
We don't have a whole lotof academic evidence of the
bad sides of short selling.
So I thought that it was importantto mention what is out there.
And I do believe that this emptyvoting topic is slightly under

(01:19:27):
researched in a governance sense.
But all right, so I think that we'vebeen chatting about this for a while...

Kate (01:19:35):
let's summarize.
Why don't you mention thethree important points to you?
And then maybe I'll do the same.

Veljko (01:19:43):
I think the big summary here is that the bulk of the evidence finds
that short selling contributes greatlyto the quality of financial markets
by facilitating the incorporation ofnegative news, both through a mechanical
channel and through an incentive todig, discover and disseminate bad news.

(01:20:05):
It has a separate positive effect onmarkets through the governance channel by,
keeping managers a little bit more honest.
And then finally it has subtle andyet probably the most important and
meaningful in economic terms effectin improving the quality of markets

(01:20:29):
and in particular market liquidity.
And we didn't mention this,but there's an important paper.
Alessandro Baber and Marco Pagano,Journal of Finance, 2012, defines
that these improvements in marketquality and liquidity are particularly
important for small stocks.

Kate (01:20:46):
So basically, short selling is viewed as evil sometimes but, when
we look at the empirical evidenceand when we look at the actual data,
the data suggests that short sellingis not evil because short selling
allows for information to be properlyreflected in prices in the stock prices.

(01:21:10):
And also it has a disciplining effect onmanagement where, you know that somebody
can short sell your company, you'regoing to be less likely to participate
in fraud, to misstate earnings and tryto mislead your shareholders basically.
Then also there's some additional benefitsof short selling for this plumbing of
the financial markets, where dealerscan better manage their inventory.

Veljko (01:21:35):
At some point, you have to figure out what do you mean with evil, right?
And what philosophical paradigm doyou take, I think that implicitly,
we are being utilitarian here.
We are asking, is short sellingcontributing to the welfare of society or
taking away from it, The implicit argumenthere is that better pricing efficiency

(01:21:56):
leads to better allocation of resources.
Better allocation of assets toefficient use means more jobs, faster
growth, more food for all of us.
And in general, higherlevels of prosperity.
Morality is subjective, andapparently the Pope would
perhaps disagree with us, right?

Kate (01:22:15):
Well, we don't know how he's going to reply to the CFTC statement yet.

Veljko (01:22:21):
The CFTC statement was followed by the Vatican's ban on
short selling for its own internalfunds, it's interesting because the
Vatican is not, necessarily contesting.
Well, as you say, it would beinteresting to see, have they thought
about, all these higher level effectsor is this a knee jerk reaction?

(01:22:43):
But it's interesting that they'retaking a blanket view of profiting
from the misfortune of others is wrong.
And if you take that statementat face value then it's kind of
hard to defend short selling.
I mean, you are profitingfrom the misfortune of others.
You and I seem to buy this idea thatprofiting from a misfortune that we

(01:23:06):
haven't caused is perhaps okay, right?
but the Vatican didn't necessarilyput that disclaimer out there.

Kate (01:23:13):
Well, I think, the hopeful message to me out there is that if a
company is indeed good and the shortsellers were wrong, then the company
is going to continue to perform well.
And short sellers are going to gethurt and lose money on their position.
On average short sellers are correct, butthere are circumstances where, as Alice

(01:23:34):
Bonaime's paper with Leonce Bargeronshows, there are cases where firms end
up going against short sellers and end upreally showing that they're good firms.
So that's the good recourse there.
And then the short sellers are theones who are losing out because they're
already in a high risk position.

Veljko (01:23:54):
I think we almost managed to go the full episode without talking
about the most shorted company ever.

Kate (01:24:00):
Tesla shorts.

Veljko (01:24:02):
Yeah, indeed, right?
I mean, and I'm so torn here, I've for along time believed that Tesla is a bubble.
And there were a lot of shorts outthere that, seem to believe so as well.
And they have put theirmoney where their mouth is.
And yet they have lost massiveamounts of capital because the share

(01:24:23):
price just keeps going up and up.
so I don't know is Tesla the exceptionhere that confirms the rule and just
proves that short sellers are notgoing to bring down a healthy company.

Kate (01:24:37):
Well, hindsight is 20/ 20 and time is on our side.
So time will show.

Veljko (01:24:44):
Indeed, indeed.
So Kate, it's probably timeto call it a night, right?

Kate (01:24:50):
Yeah, I think we've covered a lot of anecdotes, a lot of information about
short selling, what is short selling?
How does short selling actually occur?
If I were to summarize everythingit's to say, Uh, to our listeners,
do not be afraid of short selling.
short selling makesmarkets more efficient.
Short selling brings importantinformation to the markets and short

(01:25:15):
selling also improves liquidity.
So there's many benefits to short selling.
Even though people might have a naturalemotional dislike for short selling,
it has a useful disciplining effectand a useful effect of bringing in
needed information to the market.
So, I'd say don't beafraid of short selling.

Veljko (01:25:38):
I'm just afraid of somebody quoting you out of context here.
I would tell to our listeners.
You should be very afraid ofshort selling, I fully agree with
what you're trying to say, Kate,don't have a negative perception.

Kate (01:25:50):
Don't have a negative perception of short selling perhaps.

Veljko (01:25:54):
Correct.
And don't be afraid of short sellers.
They keep prices in check and they keepmarkets honest and they burst bubbles.
Be very afraid of short selling, right?
It exposes you to a potentially unlimitedamount of risk, if you're short selling.
Make sure you know what you're doing,make sure you follow the advice of

(01:26:18):
investment professionals and notof Kate and I, we are not here to
tell you how to manage your money.
Please don't sue us and be very,very careful if you're short selling.

Kate (01:26:30):
Excellent.
Thanks for listening.
We appreciate your time.
And if you liked our episode, pleaseleave us some comments, listen to
us on your favorite platform and,

Veljko (01:26:41):
And send us your questions in finance.
Cheers.

Kate (01:26:45):
Cheers.

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