Short selling is a controversial investment tool. There seems to be a deeply ingrained view that short sellers are mere speculators whose aim is to mercilessly bring down otherwise sound companies to make a profit, to the detriment of the ‘real economy.’
The recent campaigns launched by a group of retail investors participating in the WallStreetBets group on Reddit have snowballed into thousands of other Reddit users and retail investors massively buying shares and out-of-the-money call options on several stocks, the two most iconic ones being GameStop (videogames retailer) and AMC (entertainment). These campaigns have caused significant surges in share prices disconnected from these companies’ fundamental value. The main goal was to ‘squeeze’ the short positions of hedge funds on these stocks (ie forcing them to unwind their positions when the stock price crosses a certain threshold), following detailed instructions on how these strategies should be conducted. To do so, these investors, most of them unsophisticated, were advised by a few ‘gurus’ (the same ones who got the campaign started) to enter into transactions artificially pushing share prices up and forcing short sellers to buy shares back in order to cover their positions.
The depiction of short sellers as harmful investors for both financial markets and the real economy seems, however, clearly misguided. While driven by the search for investment opportunities, short sellers (and especially activist ones) play an essential role in financial markets by uncovering not only overvalued companies benefiting from capital misallocation, but also the most egregious instances of fraud and accounting manipulations. Had it not been for short sellers, frauds such as those perpetrated at Wirecard might have continued for years, resulting in much greater harm to society at large. Academic research furthers this claim by showing that short sellers played a useful role in limiting the devastating effects of the 2008 financial crisis. Although undesirable practices, such as ‘naked’ shorts in contravention of applicable bans, should certainly be monitored and sanctioned, properly conducted short selling is a key component of well-functioning capital markets. At the end of the day, the true winners of limited short selling activity are not retail investors, but fraudsters and incompetent managers whose mischief takes longer to discover.
The events that have surrounded these campaigns raise the following question: can investors who provoked the surge in the share price of GameStop, AMC and the likes for the purpose of inflicting losses on short sellers be considered as having engaged in market manipulation? From a normative standpoint, they probably should, due to the potentially detrimental impact of their action on the well-functioning of financial markets. But from a purely ‘black letter’ perspective, things are much less obvious, as questions remain, in US law, on whether market manipulation is understood to require the intended use of deceitful or misleading devices and, in EU law, on the practical application of various possible criteria such as the fixing of the price at an abnormal or artificial level.
Beyond the technical legal debate, the GameStop case carries substantial policy implications. There is a clear perception by the general public that professional investors play by a different rulebook, which would be accentuated if retail investors were to be prosecuted for market manipulation because they did something that professional investors themselves have been doing (or at least have been perceived to be doing) on a regular basis and for a long time. In particular, short squeezes have been implemented by issuers and institutional investors alike to make a profit or get rid of cumbersome short sellers for decades without being prosecuted for market manipulation, with only a few exceptions (eg Volkswagen/Porsche in 2008 and MAAX Holdings in 2012). Market authorities—starting with the SEC, which announced a few days ago that it would review the events surrounding the GameStop ‘meme trade’—need to avoid giving the general public the impression of favouring institutional investors over retail ones. From this perspective, it helps that the limited resources available to financial market authorities would make it very difficult, if not impossible, to effectively prosecute and sanction the myriad of investors who participated in these campaigns.
A good compromise would be to focus enforcement on ‘gurus’ leading retail investors into these campaigns, who advised their followers to increase their position on GameStop’s and other issuers’ stock while claiming that they would benefit from an easy exit from their position before stock prices plummet. There could be a strong case for market manipulation against these leaders, who both called for short squeezes and misled retail investors. Even if the intended use of deceitful or misleading devices was required to prove manipulation, gurus who led the GameStop movement were arguably experienced investors, and probably wouldn’t be able to convince regulators that they actually expected the stock price to keep rising without subsequently falling back significantly. In addition, enforcement against these leaders would certainly raise fewer policy concerns, as their conduct would be more easily understood by the general public as warranting censure.
Furthermore, regulators should profit from the temporary salience of short squeezes to address the question of how these practices should be regulated in the future. Despite their bad press, the virtues of short sellers for financial markets, and ultimately the real economy, are no longer a matter of doubt. At the same time, short squeezes represent a significant and, arguably, unjustified cost for these investors. Issuers, institutional and retail investors alike should be discouraged from engaging in this kind of practice. We can only hope that the GameStop case will be used by regulators on both sides of the Atlantic as an opportunity to specifically regulate the most egregious forms of short squeezes, rather than relying on market manipulation rules that have failed, until now, to adequately address this issue.