Short-Selling Manipulation: A Recurring Threat
“Robinhood” by Andrew Neal is licensed under Pexel.
In late January, GameStop, a video game retailer that was expected to close hundreds of stores in 2021, made a stunning comeback in the stock market. Retail investors from the Reddit “WallStreetBets” community increased the stock prices by bidding on the stock of companies heavily shorted by Wall Street, such as Gamestop, in the hope of inflicting losses on hedge funds that had bet against the companies. Commission-free stock trading pioneers Robinhood and WeBull took steps to curb retail investors’ trading activity. Initially, these platforms abridged the stock market’s ability to democratize wealth. Now, they are being accused of engaging in activities contradicting free-market principles by restricting the purchase of Gamestop stocks. Speculation emerged that Robinhood was colluding with hedge funds to protect their short positions, which its CEO refuted. The U.S. Securities and Exchange Commission (SEC) warned the brokerages that it will “closely review” the actions they took to restrict trading various stocks. However, this statement from the SEC did not curb any anxiety among retail investors and their supporters, Dallas Mavericks owner and Reddit-favourite Mark Cuban publicly shared his distrust of the regulatory agency.
Short-sellers have earned a negative reputation as they tend to profit from investors’ misfortune. Abusive institutional short-selling is market manipulation that Canada has seen no shortage of. Their reputation follows them here in Canada, as calls for legislative reforms on abusive short-selling have been a recurring theme in market-regulation conversations. In the United States, the failure of market regulators to prevent manipulation in stock prices reveals a failure of enforcement rather than bad policy - a contrast with Canada’s lack of policy towards manipulative short-sellers.
How Wall Street Short Sellers Manipulate the Market
According to the SEC, market manipulation is defined as “transactions which create an artificial price or maintain an artificial price for a tradable security”, i.e. a deliberate attempt to interfere with the free and fair market. Some hedge funds have regularly engaged in market manipulation, and therefore calls to regulate their activities have been prevalent. Market watchers in Canada have also called to investigate and crack down on abusive institutional short selling.
Short-sellers borrow a stock, sell it, and hope to profit if they can buy back the same number of shares of the same stock later at a lower price. Short selling is fundamentally a bet against a company; hedge funds such as Citadel and Melvin Capital shorted GameStop stocks as they anticipated that the video game retailer would fail. Though shorting intuitively sounds unethical as the trader profits from an entire business going bankrupt, it is an integral strategy of the stock market. Short sellers enable the market to function smoothly by providing liquidity and reality-checks to overvalued stocks.
This trading strategy is very risky but offers very high rewards, and consequently, institutional investors have used short-selling dishonestly to manipulate the market. CNBC’s Jim Cramer, host of popular stocks news program “Mad Money” and former hedge fund manager, publicly acknowledged organised manipulation by market giants. By spreading disinformation around markets, short-sellers bid to force down the price of a stock to cover their short positions – even when they are wrong. In the 1930s, the SEC adopted a regulation, the uptick rule, to prevent this type of manipulation by stating that a short sale may only occur if the last price movement of stock was upwards. The regulation had three main objectives: first, to continue to incentivize short sellers in bull markets; the second to prevent manipulators from driving the stock of a price down; and third, to prevent short sellers from exhausting all bids at one price level. But the growth of the stock market prompted the SEC to repeal the rule in 2007 – right before the 2008 market crash.
Current Regulations Around Abusive Short Selling
Naked short selling is another form of manipulative short selling where traders short securities without borrowing the asset from someone else. If a stock drops and the shares can be purchased at a lower price, the trader will exit their position by a “covered” short. Once the shares are bought back, the short sale is closed. In 2005, the SEC adopted Regulation SHO to tighten restrictions on abusive short selling. Under this regulation, brokers are required to have a reasonable belief the security to be shorted can be borrowed and delivered on a specific date before the short-selling occurs. According to a CRS report, the regulation was not efficient to curb naked short selling. Regulation SHO was not a bad policy; the problem lies in its enforcement.
Following the October 1929 stock market crash, the United States Congress passed the Securities Exchange Act to restore public confidence in US markets. Passed in 1934, the Securities Exchange Act created the SEC; becoming the regulatory body in the United States responsible for protecting investors, maintaining a fair and efficient market, and facilitating capital formation. However, the agency has been criticised for being too fearful in confronting the wrongdoings of Wall Street. The SEC has engaged in important regulatory changes with the goal of weakening the regulatory system in the stock market prior to 2008. The commission had succumbed to the anti-regulatory climate in the United States which resulted in the market crash of 2008, with disastrous consequences for investors. After sixty-five years of the uptick rule able to moderately regulate manipulative short-sellers, the SEC repealed the policy after it conducted a pilot program concluding that the rule was “unnecessary to prevent manipulation”. Evidently, the market crashed and the uptick rule was re-implemented in 2010 with new amendments. Several other amendments were added to the regulation and their effects are still being examined today.
In a sense, the SEC is a regulatory body where regulators tend to lean against regulations. Former trial attorney for the SEC, James Kidney, had addressed the many conflicts of interest present with numerous important staff members of the SEC. Thus, the SEC’s priorities shifted from protecting investors to protecting investment firms it is required to regulate. The commission’s anti-regulatory stances are most evident when it persuaded the Supreme Court for many years that market regulations stifle economic growth. However, it is important to note that excessive restrictions upon short selling can have negative effects on the market. As stated previously, short-sellers are essential traders as they keep stocks from inflating and correct share prices.
This type of manipulation is on the rise in Canada: Canadian equities are increasingly being targeted for abusive short selling by institutional investors. Relative to other jurisdictions, the rules of the game pertaining to market manipulation are very lenient. For instance, the SEC banned naked short selling after the 2008 financial crisis, yet it remains a legal practice in Canada. There is no distinction made between “naked” and “covered'' short sales. Furthermore, Canada has never instated a policy similar to the uptick rule in the United States which would prevent shorting stocks when a share price consistently declines. Canada’s noninterventionist approach and its focus on maintaining liquidity have created incentives to short Canadian securities, according to the McMillan law firm.
Canada has significant challenges ahead as Wall Street looks to heavily short Canadian corporations. If the free and fair market is to be protected, then market manipulation must not be tolerated. As the SEC is now launching an investigation on retail investors and traders for potential fraud, legitimate questions about the system being rigged against the “little-guy” emerge. Like any other fraudulent market practice, abusive short selling is part of the latter category. Regulatory agencies need to restore the public’s faith in their ability to regulate and to demonstrate that the same rules apply to everyone.