This might turn out to be a long, complicated post. I am not an expert in shorting shares, bonds or markets, but I did work in and around the trading operation of a large investment bank for twenty odd years. I have never shorted anything, and I didn't take part in the recent WallStreetBets inspired GameStop shenanigans. And whilst I have friends and former colleagues who work, or worked, for hedge funds, I have never done so.
So, now that the disclaimers are out of the way...
.
As much as I think hedge funds have a role to play, I have no sympathy for any that were caught on the wrong side of this. They're big boys playing a rough game and sometimes they get hurt. I have some, but very limited, sympathy for retail investors who came to the party late and got hit hard when the GameStop dropped 70% in two days recently. GameStop is a crappy underlying business - physical retail in an age of Amazon and eBay during pandemic driven lockdowns, that lost $19m in 2020 with a negative operating income - hence the hedge fund shorts in the first place; high profile and very public goings on; lots of volatility; and late to the game... Getting involved in that wasn't smart. Of course the WallStreetBets people who got in at the start and exited well made out like bandits.
1) The nature of shorts:-
One of the main functions of (financial) markets is "price discovery", ie how much is something worth? For that you need large numbers of both buyers and sellers. Shorts have a role to play here (as do futures and options, which have received far less coverage in the media recently). Shorts allow the sceptical voice to take a position based on their analysis, and sometimes they are spectacularly right. If only BaFin had listened to Matthew Earl, a short seller who called the German regulator to discuss his concerns about fraud at Wirecard two years before it went bust. They hung up on him...
Let's take an arbitrary stock that's worth $100. Person A wants to buy it because they think it's undervalued, person B agrees to sell it because they think it's overvalued. Person A is going long. Person B isn't shorting it in the market, but they are effectively "underweighting" it in their portfolio. "Real shorting" is just taking this principal one, logical, step further. It might be logical, but, as those hedge funds found out, it can also be very risky. It's risky because there is no limit to their potential loss. A stock can't be valued at less than $0. But there is no limit to a stock's potential positive value. But it is a price signal, and as such aids in "price discovery". For price discovery to be valid equal weight needs to be applicable to both positive and negative sentiment. If you remove a tool for expressing negative sentiment you run opposite risks...
There are also real "non-speculative" reasons to short something eg to hedge your risks or to manage a portfolio.
So, at least imho, shorts have a real role to play. They are also not "free". To take a short position you need to pay to borrow the stock, and you need to post margin to your broker if the trade moves against you (it's this that broke those hedge funds). To pjknibbs point about naked shorting (the practice of shorting something you haven't agreed to borrow and so can't cover) yes, it happens. Though it's meant to be illegal. There should be better mechanisms to monitor and prevent this.
All of the above is not meant to suggest that shorts are an unalloyed good. They're dangerous, their use needs to be well regulated, and there are lots of things to learn from with regard to WallStreetBets, RobinHood, and "mass retail traders". But hedge funds and institutions being reminded of the fact that there's no such thing as a risk free trade? I can live with that
.
2) Bankruptcy and the misery of others
@BrasatoAlBarolo
Shorts have no direct impact on the financial wellbeing of a company. Leaving aside the cost of raising new capital the price of a share boils down to (the market's understanding of) the value of the company's underlying assets, its future growth prospects, and expected future revenue streams.
Shorting a stock does not increase the chances of bankruptcy of the company concerned.
@jlehtone
* "misery"
Do you make money from "other's misery"? It's emotive but yes, I think you can argue that. Equally you could argue that those others shouldn't be making the money they are making because what they have isn't worth what people think it is. If I'd shorted Enron I'd be patting myself on the back, and I wouldn't give a damn about Kenneth Lay's misery. Similarly if a company is failing, the short might bring attention to it, but it's not the cause of it. It might well be a miserable time for employees, owners and customers, but that's not the direct fault of the short.
* Somebody loans their stock to you. When they get it back, its value has decreased.
a) the person (or more likely fund) that loaned their stock to you recieved a fee for doing so, b) the reason they loaned it to you is because they did not want to sell it (think about that for a second)
* Whomever you sell your stocks to will make a bad investment, because the value is predicted to decrease.
a) the act of "shorting" is selling something at below market price, b) the person who bought it from you thought that was a good deal
* The company whose stocks are traded is not doing well, if stock value decreases?
See above, largely irrelevent.
* When you buy the cheap stock (to return the loan), do the sellers make profit or are they just cutting their losses?
If our arbitrary stock was currently priced at $100 and I shorted it I make more profit the more the price drops below $100 (because I sold at $100 and bought back, to "cover my short" at what the new price was, eg $90). However if the price rises I am losing money.
* You are most likely not a person, but "faceless, greedy, scheming, filthy wealthy" hedge fund that takes and never gives back.
OK then.
3) Hedge funds
Some make a lot of money, yes. Most don't. In fact most fail. There's an awful lot of survivor bias in what most people understand about hedge funds. It's also so broad a term these days as to be largely meaningless. And they're a terribly easy bogeyman to point the finger at. clakclak's uninformed rant about hedge funds is simply that, an uninformed rant. Though were they to provide any actual reasonsing for their opinions we might be able to have a discussion about it (perhaps in a different thread?).
The notion that the 2008 house market crash (and the Great Financial Crash in general) was caused by hedge funds is simply incorrect. It's true that a couple (notably those run by David Einhorn and John Paulson) made a fortune out of shorting the sub-prime CDO (etc) market, but they called it right (they've also underperformed in recent years). Getting it right is not the same as causing it. It's probably also correct to say that the broader hedge fund industry benefited from government assistance eg TARP, but that was mainly introduced to keep the banking system alive. Banks and hedge funds are not synonymous (particularly true after Dodd-Frank was introduced).
The causes of the Great Financial Crash were, broadly speaking down to a complicated mix of the following (and I won't try to attribute how much responsibility each bears):-
* Clinton administration attempts to broaden access to home ownership.
* A frothy US housing market.
* Competition from mortage providers to lend leading to lower standards for borrowers (think "NINJA" loans - "No Income No Job No Assets" here have $250k to go buy a house).
* "No skin in the game" from mortage providers meaning they could just hand off the mortgages when they'd concluded the (shoddy) transaction.
* Those mortgages being packaged up by banks into Collateralised Debt Obligations (and worse), masking the risk whilst making it look like they were low(er) risk.
* No "skin in the game" from the banks and other institutions that packaged the mortgages up into CDOs etc meaning they could just hand off the CDOs (and associated risk) to the (naïve) institutional purchasers.
* Those mortgages being underwritten by the US Government in the form of Fannie May and Freddie Mac (see the first point above).
* Institutions (many of them foreign eg German Landesbanks) not understanding the risks they were taking on.
* The belief that because a 50 state wide drop in residential property prices had never happened before it could never happen.
* The over-reliance of banks on wholesale funding markets rather than "stickier" deposits.
(* Perhaps a global savings imbalance leading to cheap money flooding the US, though there are competing views as to how much of a role this played).
So essentially this is what went down: Crappy mortgages packaged up and sold to banks as eg CDOs - those CDOs suddenly become worth far less than they used to be - immense pressure put on bank balance sheets (ie losses) - which leads to increased capital requirements and reluctance to lend to them in the wholesale markets - which leads to lending seizing up - which smashes the real economy.
CBJ's point about some of this resentment of hedge funds (and other large institutions) only being available to large investors has a certain ring of truth about it. This is, to an extent, inevitable. Individuals rarely have the ability to conduct large, complicated transactions because they lack both the capital and the expertise. But... when we go on holiday we buy a seat on the plane, right? We don't buy a 777 for ourselves? I never see any anger directed at airlines because it's unfair that an individual can't buy their own passenger jet. Products and markets and customers of any type inevitably have restrictions built in. Whilst this might be annoying I think it's both right, proper, practical and realistic.
4) RobinHood
I'm not completely up to speed with this, so some of what I say may be wide of the mark. Am I right in thinking that there's anger with RobinHood because they stopped people buying eg GameStop shares (to keep squeezing the shorts)? I can understand that. But do those who are angry about this understand the implications and pressure this put on RobinHood? Shares typically trade on what's known as a "T+2" basis. What that means is that the settlement date (when the buyer receives their shares and the seller receives the cash due them) is two days after the date the transaction was entered into. During that window the trading platform (in this case RobinHood) has to post collateral to its counterparty. The collateral requirements naturally increase when there is significant volatility (because there is more chance of major price swings between the transaction date and the settlement date). Collateral typically equals cash or risk free instruments like Treasury Bills (you can use lower "quality" collateral, but you have to post more of it). RobinHood didn't have the resources to manage this huge increase in risky and volatile trading. Indeed, they raised $3b, yes, three billion dollars, in new capital, to support this recent activity. This also had a necessary knock on effect on their other customers, because when they traded something other than GameStop those trades also required supporting collateral. So the GameStop trading will have had an impact across the entire platform. You start getting into very murky regulatory waters about "treating customers fairly" when that happens.
RobinHood does have questions to answer, eg their "pay for orders" relationships with inter-deal brokers (some of which are also hedge funds) like Citadel. In fact they paid a $65m dollar fine recently for not making this clear to their customers. But, to coin an old adage, "there's no such thing as a free lunch". RobinHood offers retail customers zero commission trading at prices just a smidgen away from those available to the institutional market. They have to make money somehow, right?
There are also real questions to answer about "mass retail impact" eg WallStreetBets on particular stocks (it's very Goonswarmish behaviour). If financial institutions behaved in such a way they'd be in breach of oodles of regulation and breaking many laws.
Phew, that was a long post!
EDIT: Minor corrections, don't want to get my knuckles rapped again
.
I can't breathe.
- George Floyd, 25th May 2020