Thursday, April 30, 2009

The Securities and Exchange Commission is holding a round table next week to hash out how to regulate short-selling. The SEC would be wiser to let the market decide what stocks can be sold and when.

Short-selling is a practice by which investors sell stock they think is overpriced and buy it back later after the stock price falls. To do this, investors borrow stock and sell it, hoping to replace it later with shares bought at a lower price. Going short is an alternative to the more common practice of going long, in which the strategy is to pick up stocks that appear to be undervalued with the hope that they will be worth more in the future.

Most investors are more familiar with this latter practice of buying low and selling high, but that does not mean options should be limited when there are strong indications that a stock is overvalued. Limiting short-selling means that only investors who think stocks are undervalued can participate in the market. If a shareholder can’t short-sell a stock he thinks is priced too high, he is forced to sit on the financial sidelines. This makes it a lot riskier to buy stocks.

Though companies don’t like investors who may bid down the prices of their stocks, short-selling makes markets work more efficiently. Short-sellers are important in preventing speculative bubbles by offering a way to sell stocks they think are overvalued, and short-selling also points out companies that might be exaggerating their reported profits or assets by selling off stocks that are higher than they should be. In other words, short-sellers help make sure that stock prices more accurately reflect companies’ future returns.

Short-selling produces other benefits overlooked by federal regulators. It prevents predatory pricing, in which a predatory firm is willing to lose money to force smaller competitors out of a market. By short-selling a predator’s stock, the small competitors can make money on the losses predatory firms bear when trying to force the small firms out of the market. Indeed, the longer a predatory firm keeps prices artificially low, the more money the victim firms make from short-selling, which potentially can undo the very act of predation while making markets more honestly competitive.

Almost everything involved with financial markets is greeted with disdain these days. President Obama gets away with accusing just about anybody involved in financial markets of greed, and he assigns them blanket blame for the recent market turmoil. However, in many cases, what the president generically calls greed is a necessary market function. It is in the best interests of economic actors to try to maximize profits. The market will reward or punish a business model based on its ability to deliver profits.

New regulation being pushed by the Obama administration will make financial markets riskier and thus less stable. New rules to limit short-selling in a down market expose a fundamental lack of understanding of how markets work. Speculators make profits by smoothing out price swings, not by making the swings larger. Crafting policy based on flawed economics will help create speculative bubbles and protect predatory firms. That hardly stimulates the right impulses for a recovery.

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