December 11, 2024 | Read Online

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"The most important function that fundamental short sellers bring to the market is that they are real-time financial detectives."

— Jim Chanos

What the world needs now: More short sellers

In European tournament football (aka, soccer), goals scored by the visiting team used to be worth more than goals scored by the home team.

The away-goal rule acknowledged that it's harder to score as the visitor, so in the event of a tie in the aggregate score (ie, the total score over two games, home and away), the tiebreaker was determined by whoever scored the most away goals.

Things are not so different in the stock market: Profits made from selling short are both harder to earn and more valuable than profits made from buying long — and they should, like away goals, be extra-rewarded.

Let me explain.

It's harder to earn money as a short seller because 1) most stocks go up, most of the time, and 2) profits on a short trade are limited to 100% and losses are unlimited (the opposite of being long, of course).

Selling short, however, is more valuable than buying long because short sellers — in pursuit of their own profit — provide a service to the entire market: They uncover corporate fraud.

This service is perhaps more valuable than ever because media companies can no longer sustain the expense of investigating and exposing corporate wrongdoing.

But short sellers can: Shorting a stock and then issuing a short report is the business model that helps keep finance honest.

Perversely, this has made short sellers unpopular because it seems somehow unethical.

But shorting first and issuing a negative report second is no different than doing the opposite (buying a stock and then writing a positive research report on it), which everyone does and no one has a problem with.

Short sellers are nevertheless portrayed as predatory Gordon Gekko-types, profiteering from the demise of the vulnerable companies they target.

But having dabbled in short selling myself, I can't imagine that any professional short seller is in it just for the money — if you have the skillset required to uncover financial fraud, there are far easier ways to make a living.

This is not unique to short sellers. In his most recent book, Nate Silver noted that "successful risk takers are not motivated by money. They live on the edge because it's their way of life."

Short sellers similarly live on the edge, being perpetually one GameStop-sized squeeze away from going out of business.

But it's not just the thrill of living dangerously that motivates short sellers.

The short seller Carson Block says that while he found long investing to be "just about making money," activist short selling gives him "a real sense of purpose."

Block told CNBC in 2011 that short reports issued by his firm, Muddy Waters, had led to eight stock-market delistings and two successful regulatory actions — and that he believes this is not just laudable, but patriotic: "When we're out there protecting investors…that to me seems to be pretty American."

At the risk of sounding naive and corny, I agree.

There are more recent examples of short sellers' heroism, of course.

Short reports issued by Hindenburg Research led to the conviction of Nikola co-founder Trevor Milton on charges of securities and wire fraud, exposed Tingo Group as "a massive fraud," and raised questions about accounting practices at high-flying Super Micro Computer — to the immense benefit of investors that would have subsequently invested in them.

But it's not just investors who have been saved from bad investments — corporations have been too.

General Motors, which was duped into agreeing to buy 11% of Trevor Milton's Nikola, was able to renege on the deal after Hindenburg issued its short report just two days later.

That saved GM both the $2 billion it intended to invest and the untold damage to its reputation.

For every corporate fraud exposed by short sellers, however, many more go undetected, so we need much more of this.

But we're not likely to get it because short reports often invite lawsuits from deep-pocketed corporations, coordinated short-squeeze campaigns, and public scorn — even when the short seller is obviously in the right.

Consider that in the aftermath of the Luna crash in 2021, there were widespread calls to expose and possibly prosecute the short seller who allegedly kicked it off.

I agree that we should be hunting down whoever it was that targeted Luna — so that we can give them a reward.

Because imagine the consequences if the Luna bubble had been allowed to inflate for another year or two — crypto may never have recovered from the much bigger crash that would have inevitably ensued.

Or, worse yet, Sam Bankman-Fried could be president.

To help preempt similar such disasters, we should be incentivizing short sellers like Muddy Waters and Hindenburg Research, not pillorying them — the government pays financial whistleblowers to report corporate malfeasance, so why not pay short sellers too?

The whistleblower programs are meant to bolster law enforcement and government agencies that only have the resources to punish fraud after the fact.

They are "financial archaeologists," as Jim Chanos puts it, which doesn't do forward-looking investors too much good.

Short sellers, by contrast, are financial detectives that do the forward-looking work that law enforcement and government agencies never could — and also a financial "fourth estate" doing the investigative work that the modern media can no longer afford.

As such, short selling has positive externalities that should be incentivized by making the profits from selling short count more than the profits from buying long.

So here's my policy proposal to encourage more short selling: Make the profits tax-free.

Europe scrapped the away-goal rule in 2021 because it was encouraging home teams to play too defensively, which was boring to watch.

But playing defense in financial markets is a good thing — we should help short sellers do more of it.

— Byron Gilliam

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Eric Balchunas @EricBalchunas

Nice chart showing ETFs % contribution to issuers' total revenue. Mind-melting that after all that success, ETFs still just 0.3% of JPM's revenue. Damn. And GS they just 0.1% (which was the point of note: GS doesn't need white label biz, which they selling) via @psarofagis

4:41 PM • Dec 11, 2024

43 Likes 6 Retweets

6 Replies

Ryan Watkins @RyanWatkins_

When you realize agents will be the primary form factor for users to interface with blockchains, it becomes clear that agentic infrastructure isn't just about launchpads, it's about building the operating system for the future of the onchain economy.

7:54 PM • Dec 11, 2024

95 Likes 14 Retweets

21 Replies