The GameStop trade needed short-sellers to work—and so do markets

Short-sellers spotted the fraud at Markus Braun’s Wirecard before regulators did.
Short-sellers spotted the fraud at Markus Braun’s Wirecard before regulators did.
Image: Reuters/Fabrizio Bensch
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Short-sellers have always been unpopular, and they’ve managed to become even more disliked during the GameStop controversy. But in a time when the stock market appears ever less connected to economic reality, these controversial investors are more needed than ever.

What’s a short-seller?

When investors believe a business’s stock price is on a downward trajectory, they can bet on their belief by borrowing shares from other investors, with a promise to give the stock back in a certain time period, plus some interest.

A stylized example: The short investor borrows a stock, let’s say at $10, and sells it. When the stock price drops to $5 the next week, they buy the shares back, return them, and pocket a $5 profit. If the stock instead rises to $15, the short investor either closes the trade for a $5 loss, or pays more interest to keep the trade open. For short-sellers, the risk can be immense—there’s no ceiling on how high a stock can soar, meaning their losses can climb indefinitely.

The wild rise in GameStop’s stock first required many bets against its future. Investing enthusiasts on Reddit knew the hedge funds that were short-selling GameStop were vulnerable to a “short squeeze”—as long as buyers can keep the price of the stock rising, short-sellers would eventually be forced to buy GameStop shares to contain the damage. When hedge funds do this (called “short covering”), that provides another uplift for stock prices.

There was another feedback loop at play: traders were also buying lots of options for GameStop stock. Market makers selling options then bought GameStop shares to hedge themselves against losses if the options pay out. These dynamics created a vortex of demand for GameStock stock. As the game retailer’s shares skyrocketed, at least two hedge funds have closed their positions with huge losses.

Is short-selling bad?

Many people ascribe a moral dimension to short-selling. Often, these are corporate leaders who do not like to see people bet against their enterprises, for obvious reasons. Elon Musk is our most famous contemporary critic of short-sellers, who have targeted his electric car company Tesla virtually since it went public. In response, Musk toyed with taking the company private and produced derisive merch, but his real revenge was simply Tesla’s performance, which has made him the wealthiest man in the world. Former New York Stock Exchange president Tom Farley once said short-selling was “un-American”—but again, you can see why he would say that: his job was to cheerlead the stock market.

It’s interesting, then, that many people who aren’t corporate titans also think short-selling is bad. The idea of betting against a company’s success can be seen as somehow an attack on the company’s workers, or other regular investors who have bet on the stock. But this view is a mistake: Unless some huge percentage of your wealth is tied up in a single firm, short-selling is better for the average investor because it pushes back against bubbles and corporate malfeasance. Creative destruction is painful for workers, but their career prospects are likely to be better the sooner they go to a dynamic, healthy enterprise and leave a corporate zombie.

“Short-sellers, when it’s done right, are healthy for the market,” says Joshua White, an assistant professor of finance at Vanderbilt University. “Academic research on that is very clear. If we didn’t have short-sellers in the market then the stock prices would potentially be too high.”

That may seem ironic, since short-selling indirectly created the GameStop bubble. But if there is one major complaint about markets, it is that they are too disconnected from the real economy. The valuation of some companies is no longer linked, even vaguely, to their potential to generate future cash flows. Many have complained as the US stock market increased the wealth of billionaires in 2020, even as the US put in its worst economic performance since 1946.

One way to help keep the market honest is to short stocks whose business plans don’t add up, or whose business is illegal. Studies have found strong evidence, around the world, that fewer constraints on short-selling contributes to more efficient markets. That’s not only through more accurate prices, but also because short-sellers provide additional income to long investors whose shares they borrow, and because short positions are often used by sophisticated investors to hedge other positive bets.

Here’s another way to think about it: the list of people who want stocks to go up is lengthy—politicians, investors (retail and institutional), corporate executives, arguably even financial regulators are incentivized to want the market to rally. The person with the lone voice going the other direction isn’t going to make many friends, but that voice is important if you want markets to find fair values.

Short-selling’s greatest hits

Betting against companies is arguably even more important to people who care about policing corporate misconduct.

“After corporate lobbying has caused decades of intentional underfunding of enforcement agencies, activist investors—including activist shorts—are one of the only remaining well-funded investigators of corporate conduct,” Brennan Bilberry, the co-founder of Elk Hills Research, told Quartz. “If you’re rightly concerned about the disturbing concentration of corporate power today, you should want more activist investors with a financial incentive to take on entrenched corporate management.”

Consider the tale of Wirecard, arguably the biggest corporate scandal of 2020. The German payments processor, a darling of the country’s fintech industry, attracted public doubts about its financial reporting as early as 2008, but regulators instead charged the men who made the allegations with stock manipulation. Still, questions did not go away, and after the Financial Times published an expose, Wirecard accused the newspaper of collaborating with short-sellers (it had not). The ire of German regulators against critics of the company was such that shorting its stock was banned for two months.

You may know how the story ends: In June 2020, Wirecard admitted its books were fraudulent and missing €1.2 billion ($2.4 billion); its CEO is under arrest, and its COO remains an international fugitive. Without pressure from short-sellers and journalists, this fraud would likely have continued with nary a concern from the authorities.

There are other examples: Capitalizing on an investigation by an environmental non-profit, short-seller Whitney Tilson profited from a bet against the firm Lumber Liquidators, which had goosed its margins by purchasing cheap wood harvested from the habitat of endangered Siberian tigers and sold lumber contaminated with formaldehyde. Another short-seller, Carson Block, made his name investigating Chinese companies listing on Western stock exchanges, finding notable frauds like Sino-Forest.

Can shorts go wrong?

In 2017, three bombs exploded near a bus carrying the Borussia Dortmund soccer team, injuring several players. An investigation revealed that the culprit, Sergej Wenergold, had planted the explosives in an effort to drive down the publicly traded stock of the soccer team. He had purchased put options—financial instruments akin to short sales that represent a bet the price of a stock will fall. But the stock did not fall precipitously, and Wenergold was sentenced to 14 years in jail.

That short-selling will lead to actual sabotage is often alleged by CEOs whose companies are under pressure, but there are few substantiated examples as dramatic as this one. For one, the up-front cost of options is fairly expensive for most criminals (Wenergold’s cost €78,000) and trades are fairly well monitored by regulators.

Another protection from pernicious results are regulations that aim to stem market manipulation. After the financial crisis, the SEC tightened US rules on shorting stocks to prevent “naked shorting,” the practice of betting against a stock without actually borrowing the underlying security. The US also added another rule, the uptick rule, to prevent short-sellers from piling on to a falling stock.

In practice, these features make short-selling a fairly risky investment strategy. Even strong evidence of fraud may not be enough to shake market confidence, and more often short investors are making more subtle arguments about a failing business model. Hedge fund investor Bill Ackman spent five years trying to convince the world that Herbalife was a pyramid scheme, and failed. Tesla has yet to be brought low by short-sellers. And like the GameStop antagonists, short-sellers are always vulnerable to a squeeze, like the one that briefly made Volkswagen the world’s most valuable company in 2008.

It isn’t getting easier for short sellers. Last summer, Block told Quartz that it has become increasingly difficult to get through to investors with his messages about fraud and overvalued companies, even as the stock market becomes more unhinged from economic reality. “I feel like the bar has been getting raised every year, just in terms of being able to tell stories about companies that are engaging to investors and that they think matter,” he said.

One firm known for the strategy, Citron Research, which got burned in the GameStop short squeeze, says it will stop publishing short research. Founder Andrew Left says the firm will now focus on recommending stocks that it thinks have promise.

Short-sellers are probably used to seeing themselves as the Davids against the Goliaths of other interests, from politicians to corporate executives. In a bizarre twist, short-sellers now find themselves hunted by armies of retail investors, and the public and political class is mostly siding with the retail traders. That’s understandable—it’s hard to have much sympathy for hedge fund managers. But the biggest risk to the market is a populist backlash that puts new limits on the only people with an incentive to call out bullshit rather than prop it up.