Banning short selling in India during this crisis would worsen the underlying issue
There is no dispute that calming markets is important but a ban on short selling helps no one; it only provides the illusion of relief, while giving a free pass to companies that should be under scrutiny
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India is not new to short selling. The first short-sell in history is said to have been executed by Isaac Le Maire, after exiting the Dutch East India Company. Le Maire is believed to have spread rumours that hurt the company stock. The stock price began to drop, so the Dutch East India Company did what a company today might do: Asking for a ban on short selling.
Their claim was that short-selling their stock would hurt society's most vulnerable. Dutch East India Company could hardly be considered vulnerable at the time; however their reasoning was that widows and orphans were a large portion of stakeholders in their stock.
This is how, simplistically, many today understand short-selling. This could not be further from reality.
However, if the convertible sheds its value, the embedded equity option also loses its value. To hedge this risk, investors can choose to simultaneously buy the convertible, and short the stock. It’s not just convertible bond buyers either. Credit investors also use equity short-selling to protect their positions in senior debt, given shares tend to fall further, and faster, than securities further up the credit stack in times of distress.
One study found that short-selling bans on financial stocks actually increased the probability of both default and volatility in the targeted companies. Another 2013 working paper found the same. In the EU Commission report on short selling, IMF staff wrote, “Short selling has many benefits which help improve market quality. It augments liquidity and for every (short) seller there is a party on the other side of the transaction who is willing to pay the given price”.
According to Activist Insight’s Activist Short Selling report published in May 2018, when it comes to types of short-sellers campaigns that are most profitable, corporate fraud, stock promotion frauds, and accounting frauds are at the top, returning from 11 percent to 13 percent in one week of the short-sell.
In the long run, fraudulent stock promotion is the most profitable, generating 41 percent in one year on average, followed by claims of a company’s product being fraudulent, which resulted in a return for a short seller of 32 percent on average (in one-year period). Corporate fraud averaged 23 percent returns, while accounting frauds lagged with the average return of two percent. Bringing down corporate fraud essentially is a common threat in most successful short-sells.
Yet short-selling’s rich history of uncovering corporate fraud is ignored and the former two narratives have taken precedence.