This started life as a comment on The Alternative "No Bailout" DeFazio Plan, but as it grew longer and longer, I realized that it was more of a diary than a comment.
There has been a lot of press recently blaming short selling for the declines in markets- and a number of people not as familiar with the markets have even started questioning why we allow short selling at all. The problem is that the role of short-selling in the markets is not well understood. I now work for a company that does a lot of short selling (not as a trader- I'm not as informed about this as many people I know), and I'd like to set the record straight. Most short selling is, in fact, good for the market as a whole (not just the short-seller). And, more importantly, short sellers can not "destroy" a healthy company.
There is a reason why short selling is a good thing to have in the market. What do you need to have a market? Well, you need three things- something to trade, someone willing to buy, and someone willing to sell. Now, what a lot of companies do (including, full disclosure, the one I work at, albeit not as a trader) is perform a roll called market making- which means that for some security, they're willing to be- constantly!- both a buyer and a seller.
Now, everyone likes the facts that market makers exist- because, in financial terms, market makers decrease volatility and increase liquidity. Market makers act as a time-based middle-man, connecting buyers (or sellers) now with sellers (or buyers) later. And before you badmouth middle-men, this is in effect the same service your local grocer provides, except he's connecting geographically distant cooks and food producers, instead of timing distant buyers and sellers.
But you run into a problem trying to be a market maker if the buyer comes first. The market maker may think that $30 is a fair price for the stock, and thus be more than willing to sell the stock for $30.05, but since the market maker doesn't own the stock, can't do anything about it. And the fact that in a couple of minutes, or hours, or days, someone else may be willing to sell the stock for $29.95, that doesn't help right now, for the poor schmuck wanting to buy the stock. He's going to get screwed- the price will keep going up until he drops out- or until someone rips his face off, selling him a $30 stock for $35, $40, $50, whatever. At which point the price will immediately drop right back down to the fair market value.
These radical changes in the prices of the stock is the volatility of the stock. The liquidity of a stock is just the number of buyers and sellers for the stock. Big name stocks, like Microsoft or GE, have lots of liquidity- lots of people willing to buy and/or sell the stock at any given time. Small stocks, not so much. Highly liquid stocks also tend to be much less volatile. Having a market maker in a stock guarantees at least one buyer and one seller- having two or three market makers in a stock (not uncommon) means you always have two or three buyers and sellers- instant liquidity pool.
This is where shorts become valuable- to the market as a whole, not just to the guy shorting the stock. Shorting the stock allows the market maker to sell the stock now, at something close to the fair market price, and buy it back later (of course the market maker generally makes a profit on the transaction- so does the grocer!). And thus it prevents the guy who wants to buy the stock from being totally screwed over- yeah, he may end up paying $30.05, or even $30.10, for that $30 stock, but he won't have to pay $31, let alone $50.
Another thing I'd like to note is that shorting stocks can not hurt a healthy, liquid stock. You can't destroy a major company shorting stocks, unless that major company was already about to be destroyed. See, the idea that short sellers can destroy the company works like this: evil short sellers pick a stock worth, say, $30, and put out a big short on this stock. Which means they sell a lot of stock at $30, more at $29, and so on until the price hits, say, $25, at which point they buy back in to cover their shorts (you do have to buy stock later to cover your shorts), and make a killing, laughing at all the suckers who bought this now-$25 stock at $30, $29, etc.
The problem with this is that it presumes that, once the evil short sellers want to buy back in, there is an unlimited amount of stock available for purchase at that price. What will simply happen is that everyone else in the market- knowing that the price is really worth more like $30 rather than $25, will simply sit- and when the poor evil shorters have to buy to cover their shorts, the price will shoot right back up again- and probably go even higher. Selling a stock at $28 and having to buy it back at $31 is a great way to make a small fortune... out of a large one.
This only works in two cases- one, where there is a lot of programmed limit orders out there, which is addressed by the various speed bumps in the market after the 1988 crash. Basically, after the market for any stock falls more than 10%, trading is halted (for increasingly long periods of time if the stock continues to fall). This allows the humans to intervene and realize "wait- these morons are selling a $30 stock for $27- don't sell, buy!" And the stock price goes right back up again, often destroying the evil short seller in the process.
The other is when the market as a whole is willing to revalue the company- in other words, when a lot of investors who are holding the stock start thinking that maybe it isn't really worth $30/share. Maybe it really is only worth $25, or $20, or maybe even $0. But in this case it's not the people shorting the stock who are destroying the company- it's whatever the company did that made the market think it wasn't worth it's current price. The short sellers are at most the messenger here. Although shooting the messenger is a time honored tradition. It may not be right, but it's convenient.
We need a solution to this credit crisis. It's not the stock market that is collapsing (a 7% drop isn't that unusual), it's the bond and credit markets that are being devastated. Which means the next thing that will happen is that any company that has any significant amount of short term debt (i.e. more than they have cash on hand), which is basically all of them, will be hit next. GE and GM also have huge amounts of illiquid (hard to sell) assets on their books. Only instead of being CDO and Credit Default Swaps, they're called "factories" and "inventory". But that difference won't matter when the credit crunch hits them, and they're having to sell their factories for fire sale prices just to pay their debts- and laying off all those good paying middle class jobs in the process. But we need to have an intelligent, thought out, workable bill, that doesn't throw the baby out with the bath water.
There are limits on short selling, and there needs to be. But, by and large, those laws already exist. Naked short selling is already illegal (unless your an official market maker- which is a position that comes with both contractual and legal obligations, including requirements that you make a fair market). Naked short selling is where you sell without a borrow- a borrow is when your clearing firm loans (aka broker) you the stock (generally for a fee). You borrow the stock from the clearing firm, then sell the stock- but you have to buy it back to cover the short in a reasonable amount of time (generally 30 days).
What we need is not new rules, but our current rules to be enforced (or, in the case of the tick rule, reinstated and enforced). We should not let panic stampede us into making bad laws we will regret.