Money as a generally-accepted medium for short selling

Jim Chanos, famous short seller. We are all Jim Chanos.

Most people find the idea of short-selling to be incomprehensible. Buy a stock and hold it, that's what one does. To the majority of us it's just down-right odd to do the reverse, borrow stock in order to sell.

At the same time, pretty much everyone in the world is a short seller, even if we don't realize it. The credit card debt we wrack up, the lines of credit, the pay day loans, the mortgages—they're all examples of us going short. We borrow a certain type of security—dollars or yen or other types of money, either in paper or digital format—and immediately sell it. And then after a little time passes we cover that short, buying the dollars or yen back and repaying the loan. We are all Jim Chanos, the world's most famous short seller, the only difference being we tend to short different instruments than Chanos does.

The only time I ever sold a stock short was back in 1999. I was still in university and probably a little bit reckless. What I didn't know at the time was that there was still a year or so left in the crazy late 1990s bull market. The price of the stock that I had shorted immediately began to move higher, and I got worried. The problem with short selling is that because a stock can keep rising forever, losses are theoretically infinite. After a month or two I bought the stock back to cover the loan, then got back to my studies.

While I've only sold stock short once, I've sold money short umpteen times. Borrow some Canadian dollars, sell it for things like groceries or a plane ticket or tuition, wait a while, repurchase the money, pay the loan back.

So why don't I finance my consumption by shorting things like Netflix or bitcoin? Why do I short dollars instead?

The nice thing about shorting money rather than Netflix shares or bitcoins is that I know exactly how much it'll cost me to repurchase the necessary securities to cover my short. Our labour is almost always priced in term of money, say $30 per hour. So if I've shorted three one-hundred dollar bills, I know ahead of time that I only need to sell ten hours of my time to buy that $300 back.

What's more, labour tends to stay sticky for months. This means I don't have to worry about my per-hour rate plunging temporarily to $15 next Wednesday, forcing me to spend twenty hours of time instead of just ten to cover my short. And since the central bank sets an inflation target of 2% or so a year, I already know far ahead of time that if I'm making $30 per hour this year, I'll be making ~$30.60 next year. So whereas one hour of my labour allowed me to cover a $30 short position in 2017, that same hour will allow me to cover a $30.60 short position in 2018. That sort of long-term certainty is a great feature.

Not so with bitcoin or Netflix. The big problem with using these instruments to finance consumption is that labour is never paid in terms of bitcoin or Netflix, but in yen or dollars or pounds. So while the sticky nature of labour means I know ahead of time that I'll be able to sell an hour of my time for $30, I don't know how many bitcoins or Netflix shares this $30 will allow me to repurchase to cover my bitcoin/Netflix shorts. This would be less of a problem if Netflix and bitcoin were fairly stable in price, but both are terrifically volatile, as I described here.

Consider a scenario in which I short one share of Netflix in order to fund my weekly supply of groceries (which costs ~$200)—or alternatively I short 0.01 bitcoins—and the price of either of these two assets doubles over the next few days. I'll end up having to pay $400 to cover the short, or fourteen hours of labour. If I had just shorted $200 dollars instead, I'd only owe seven hours ($200/$30).

A worst case scenario is one in which Netflix of bitcoin start to rise to infinity. If so, I'd have to work every waking hour of my life just to repurchase Netflix/bitcoin and cover my short. No thanks, I'll take the predictability of shorting money to pay for $200 worth of groceries. Central banks can create and cancel whatever amount of money they need to keep the purchasing power of money on a narrow path. I'll never have to worry about the nightmare of working every day for the rest of my life just to cover a tiny short position.

-----

Without the institution of short selling, society is made worse off. The timing of people's incomes do not always coincide with their consumption plans, and a short sale is a great way to bridge the gap.

And if short selling is a vital tool for bridging the gap between our incomes and consumption plans, it is important that the various media we use for shorting are capable of facilitating this process. When the future costs of covering a given short are difficult to predict, people will shy away from shorting to fund their spending needs, and the benefits of trying to bridge the gap between income and consumption plans will go unexploited. Society is made worse off.

The best media for this purpose—those most capable of providing a predictable price—will become society's generally-accepted media for shorting. So maybe money isn't just a medium of exchange, store of value, and unit of account; it's also a popular short-selling medium. That's why we see stable instruments like Federal Reserve dollars or Bank of Tokyo-Mitsubishi yen deposits or Barclays pound deposits serving as the world's most prolifically-shorted media. Sure, bitcoin and Netflix short sellers certainly exist, but this is a very niche sort of transaction undertaken by highly-trained financial practitioners or fools. They aren't generally-accepted short media.

-----

Bitcoin is a particularly awful medium for short selling because its lack of fundamental value leads to jaw-dropping volatility. Anyone who borrows one bitcoin (which currently trades at $19,000) and then sells it to finance a $19,000 purchase, say a car, could easily end up owing $190,000 two or three months down the road. That'd be a mere 10x price increase in the price of bitcoin, which is just a regular month or two in bitcoinland. A price move of this degree could easily bankrupt the car buyer.

Which in turn could bankrupt the person who lent to them. A bitcoin lender must account for the potentially lethal effect bitcoin's price spikes will have on his or her customer base by incorporating a premium into the interest rate charged to their customers. This means that the interest costs of borrowing and shorting $19,000 worth of bitcoin in order to buy a car will always be more than the costs of borrowing $19,000 worth of Federal Reserve banknotes. 

Because this volatility is inherent to bitcoin, it will always be bad at helping people build vital bridges between incomes and consumption plans. Don't expect it to ever become a generally-accepted medium for short selling.    

-----

What other features make for a good generally-accepted medium for shorting? When it comes time to cover one's shorts by buying back Netflix or bitcoin, there may not be enough of these instruments available, which can lead to a huge spike in their price. These are called short squeezes.

Money is different. The supply of modern money is tiered, with the public at the top, commercial banks in between, and a central bank at the bottom layer. When a spike in the public's demand for money occurs (otherwise known as a bank run), private banks will try to accommodate that spike until they can't, at which point they can turn to the central bank for help. The central bank can in turn manufacture whatever quantity of new money is necessary to meet that demand. So short squeezes will always be prevented by the central bank. That's a feature that neither Netflix nor bitcoin can offer.

-----

If the central banker's job is to maximize people's ability to bridge long gaps between income and spending by ensuring the predictability of the generally-accepted medium for shorting, might there be a better rule for managing things than inflation targeting?

Say that a recession hits and a large part of the population loses their jobs. If the central bank has an inflation target, those who have jobs can continue to easily cover the same quantity of dollars shorted by selling their labour whereas those without jobs will not be able to cover their shorts at all. Aggregating these two groups together, there is a net reduced capacity for short covering. So we might say that the central bank is failing at its job of providing a predictable medium for shorting.

If the central bank were to temporarily boost inflation to 4% when a negative shock occurs, it would be easier for the unemployed to cover their shorts than under a permanent 2% inflation targeting regime. For instance, with inflation at 4% rather than 2% an unemployed person would be able to sell their car or couch at a higher price than otherwise in order to cover a short position. For those on the flip side of the coin—those who make their living lending the medium for shorting—a temporary increase in inflation to 4% means their loans will be less valuable. But at the same time, the increase in the odds that the unemployed will be able to cover their shorts means that creditors needn't fret so much about the hazards of bankrupt customers.

So everyone wins. The converse could work too. When the economy is booming and jobs plentiful, the central bank could reduce inflation to 1% or so, thus making it slightly harder for people to cover their short positions. By using a rule that improves predictability in both regular times, downturns, and booms, the central bank provides a superior shorting medium for bridging gaps between incomes and consumption plans than under a flat inflation targeting regime. I suppose this is an argument for NGDP targeting over inflation targeting?

Even cheaper than an ETF

John Bogle, father of passive investing

With fees as low as 0.10%, passively managed ETFs are one of the cheapest ways to get exposure to equities. Not bad, but here's a financial product that would be even cheaper for investors: an equity deposit. I figure that equity deposits would be so cost efficient that rather than charging a management fee, investors would be paid to own them.

To understand how equity deposits would work, I want to make an analogy to bank deposits. Think of an equity ETF as a chequing account and an equity deposit, or ED, as a term deposit. In the same way that chequing deposits can be offloaded on demand, an ETF can be sold whenever the owner wants, say on the New York Stock Exchange or NASDAQ. Equity deposits, like term deposits, would be locked in until their term was up up. Issued in 1-month, 3-month, 1-year, 3-year, and 5-year terms, EDs would replicate a popular equity index like the S&P 500.

Given that both ETFs and EDs track the same index, and both provide the same dividends, the sole difference between the ETF and the ED is their liquidity. A commitment by an investor to an ED is irrevocable (at least until the term is up) whereas an ETF allows one to change one's mind.  ETFs represent liquid equity exposure; EDs are illiquid equity exposure.

An investor might buy an ED rather than an ETF for the same reason that they might prefer term deposits to a chequing account; they are willing to sacrifice liquidity for a yield. For a trader with a holding period of a few minutes or hours, an ED would be an atrocious instrument. On the other end of the spectrum, long-term buy-and-hold investor would be perfect candidates for substitution from ETFs into EDs. Come hell or high water, investors following a buy and hold strategy have pre-committed themselves to owning equities till they retire. As such, they don't need the permanent liquidity window that ETFs provide. Now if that window were provided free of charge, then investors may as well buy ETFs. But liquidity doesn't come without a cost, as I'll show below. Which means that long-term investors who own ETFs are paying for a worthless feature.

Better for a buy and hold investor to slide a portion of the portfolio that has already been dedicated to ETFs into higher yielding 5-year EDs, rolling these over four or five times until they retire. In doing so, investors get a higher return while forfeiting liquidity, a property they put no value on anyways.

How is it that an ED can provide a higher return than an ETF? Here's how. Once investors' funds have been irrevocably deposited into a 5-year vehicle, the manager buys the stocks underlying the S&P 500. Next, the manager offers to lend this stock to various market participants, either short sellers looking to make a quick buck or market makers who want to replenish inventories. These loans, which are quite safe due to the fact that the borrower provides collateral, earn a recurring stream of interest income which the ED manager shares with the ED investor. This return should be high enough to more-than counterbalance management expenses such that on net, ED investors end up earning an extra 0.25% or so each year rather than paying 0.10-0.50%.

But wait a minute, why don't ETFs do the same thing? Why don't they lend stock and share the income with ETF investors? Actually, they already do. And in some cases, ETF managers are already providing investors with more in lending income than they are docking them to manage the ETF. See the screenshot below from an iShares quarterly report:

The iShares Russell 2000 ETF, which has a net asset value of around $25 billion, provided investors with $34.58 million in stock lending income in the six months ended September 30, 2015, well in excess of advisory fees of $27.85 million.

So yes, ETFs can and do earn stock lending income, but my claim is that an ED manager following an equivalent index would be able to earn even more from lending out stock. To understand why, we need to think about how stock lending works. Stock loans are usually callable, meaning that the lender, in this case the ETF, can ask for a return of lent stock whenever they want. Callability is terribly disadvantageous to the borrower, especially a short seller, as they may have to buy back and return  said stock when they least want to, say during a short squeeze. In order to protect themselves, a short seller will always prefer a non-callable stock loan, say for 1-year, then a callable one, and will be willing to pay a higher interest rate to enjoy that protection.

ETFs and mutual funds are not in the position to provide non-callable stock loans because ETF and mutual fund units can be redeemed on demand by investors. For instance, if performance lags a mutual fund manager may start to experience large redemption requests. To meet those demands, the manager needs the flexibility to recall lent stock and quickly sell it. As for ETFs, units can be redeemed when authorized participants submit them to the ETF manager in return for underlying stock. So an ETF manager is limited in their ability to lend out stock on a long term basis lest they are unable to fulfill requests from authorized participants. Because ETFs and mutual funds can only lend on a callable/short-term basis they must content themselves with a correspondingly low return on lent stock.

As one of the only actors in the equity ecosystem with a long-term pool of pre-committed stock-denominated capital, an ED manager is in the unique position of being able to make non-callable term stock loans. Put differently, redemption of EDs is distant and certain, so only an ED structure allows for the perfect matching of long term assets with long-term liabilities. This means EDs should enjoy superior stock lending revenues, more than offsetting the costs of running the ED.

Say that an ED can beat an ETF by around 0.5% a year thanks to its superior stock lending returns. That doesn't sound like much, but compounded over a long period of time it grows into a large chunk. For instance,  If you invest $2000 each year for 25 years in an ETF that earns 8%, you end up with $157,900. Place those funds in an ED that returns 8.5% and you end up with $170,700. That's a pretty big difference.

EDs don't exist. But if they did I'd probably sell a significant number of my ETFs and buy EDs. I could imagine putting 20% of my savings in a 5-year S&P 500 ED, for instance. What about you?

---

PS: Feel free to torture test this idea in the comments
PPS: It is very possible that this product already exists.
PPPS: The devil is in the legal details.

Related posts:

An ode to illiquid stocks for the retail investor 
A description of the moneyness market 
If your favorite holding period is forever 
Beyond Buffett: Liquidity-adjusted equity valuation 
Liquidity as static 
No eureka moment when it comes to measuring liquidity

Short selling and monetary theory

Jacob Little, legendary short seller.
The Great Bear of Wall Street
1794 - 186

This is a guest post by Mike Sproul




To understand short-selling, start with three words: “Borrow and sell.” The short-seller in figure 1 borrows a share of GM stock from a stockholder and then sells that share of stock to a buyer for $60 cash. If GM subsequently drops to $50, then the short-seller can buy a share of GM on the open market for $50, repay that share to the stock-lender, and profit $10. But if GM instead rises to $70, then the short-seller loses $10, since he must pay $70 to buy the stock before repaying it to the stock-lender.                                                      

As the short-seller borrows one share of GM, he hands his IOU to the stock-lender. This IOU promises to deliver a share of GM stock. (It would also promise to compensate the stock lender for any dividends missed as a result of lending the stock.) Since the IOU can be redeemed for a genuine share, the IOU will be worth the same as a genuine share. This means that the stock lender does not have much reason to care whether he holds the genuine stock or the IOU (unless he cares about losing his voting rights in the corporation).

Figure 2 shows a simpler way to sell short. The short-seller simply writes up an IOU and sells it directly to a buyer. This kind of short sale gives the same payoff as the “borrow and sell” short sale of figure 1. If GM falls to $50, the short-seller gets a $10 profit, while if GM rises to $70, the short-seller loses $10. This method of short selling is so simple that it can happen by accident. Suppose you're a stockbroker, and a client calls asking you to buy one share of GM for him. You answer, “OK, you got it”, and hang up, planning to deliver the actual stock later in the day. You have just gone short, and you stand to gain $1 for every dollar the stock falls, while losing $1 for every dollar it rises.

A still simpler way to go short is to make a bet with someone, as shown in figure 3. The terms of the bet are that for every dollar GM falls, the buyer pays the short seller $1, while for every dollar GM rises, the short seller pays the buyer $1. The payoffs from this bet are the same as the other two methods of short selling. The bet shown in figure 3 is like a futures trade: There is no actual delivery of GM stock, and gains and losses are settled periodically, including adjustments for dividends. In contrast, the trade in figure 2 is like a forward trade: There is a promise to deliver GM stock, and gains and losses accumulate until the position is closed out.

Some common misunderstandings about short selling:

1. Are these IOUs counterfeit shares? Do they dilute the underlying stock and reduce its value?

No, no, and no. And never mind what Overstock.com CEO Patrick Byrne says. The short seller who issues the IOU puts his name on that IOU, recognizes the IOU as his liability, and stands ready to deliver a genuine share to the holder of the IOU. These are not the actions of a counterfeiter. But suppose there are 1 million genuine shares of GM stock in existence, and that short sellers have collectively issued 2 million IOUs. In a sense, the quantity of GM shares has tripled, and you might expect the share price to fall to 1/3 of its former level. But don't forget that GM did not issue the IOUs, and they are not GM’s liability. They are the liabilities of the short sellers. The issuance of IOUs through short sales does not affect the number of genuine GM shares, nor does it affect GM’s assets, so it can't affect share price. If short selling somehow did put share price out of line with the firm's actual value, then arbitragers would pounce. There will occasionally be liquidity crises when markets break down, stocks are hard to borrow or hard to buy, and arbitrage can't play its usual role; but in normal conditions, arbitrage assures that short selling does not affect share prices. Besides, short selling itself helps to keep markets liquid, and makes these liquidity crises less likely to occur in the first place.

2. What is a naked short?

In figure 1, a naked short would occur if the short seller failed to deliver the genuine share to the buyer within 3 business days. If this happens, the “borrow and sell” short of figure 1 reverts to the “forward style” short of figure 2. The buyer ends up holding the short seller's IOU, rather than the genuine share. If the short seller fails to deliver the genuine share even after an extended period, then the two traders could still settle up with each other in cash or other securities. The “forward style” short of figure 2 would thus revert to the “futures style” short of figure 3. If worse comes to worst and the short seller defaults, then either the stock exchange will make good the loss, or the traders will get a costly lesson in placing too much trust in their fellow man. Sometimes the SEC will step in, and traders will get an even costlier lesson in placing too much trust in the government.

Note that in all three methods of short selling, the dollar payoffs to both traders are identical. This highlights the futility of the numerous restrictions that governments place on short selling in general, and on naked short selling in particular. In the first place, any legal restriction on one type of short selling will only cause traders to switch to a different kind that is not so easily restricted. In the second place, studies show that when governments do succeed in suppressing short sales, markets become less efficient.

3. Short selling and money

When you buy a house, you borrow dollars and then sell those dollars for a house. This makes you short in dollars, just like borrowing and selling GM makes you short in GM (figure 1). Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank's IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money. This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money.

It's reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued. For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$. But if the money supply and money demand curves intersect at a value of 1 oz/$, then the dollar will supposedly trade at a premium of 0.70 oz/$ over and above its backing value of 0.30 oz/$.

This is where short sellers pounce. They could borrow 10 dollars and sell them for 10 oz. of silver, as in figure 4. As they borrow dollars, the short sellers issue dollar-denominated IOUs that promise to repay $10 worth of assets (ignoring interest). These IOUs can either be used as money directly, or they can be traded for a bank's IOU, which could then be used as money. The proliferation of these IOUs will, on textbook principles, reduce the demand for the Fed’s paper currency, causing it to fall in value, let's say to 0.9 oz/$. Now the short sellers can repay their $10 loan with only 9 oz. of their silver, earning an arbitrage profit of 1 oz. (Note that they don't repay their loan with currency, since buying currency with silver would drive the dollar back up.). The short sellers profited from the inflation that they caused. As the short selling continues, the dollar will continue to fall until it reaches its backing value of 0.3 oz/$, at which point short selling is no longer profitable. (Reality check: Currency traders don't usually deal in silver. A more realistic scenario would have traders borrowing dollars and selling them for British bonds (denominated in pounds). This would reduce the monetary demand for dollars and the dollar would lose value, at which point the traders would swap their British bonds for depreciated US bonds, which they would use to repay their dollar loans.)

So here’s the problem with textbook monetary theory: If you think that money's value is determined by money supply and money demand, and that money trades at a premium over its backing value, then you'd have a hard time explaining how money holds its value in the face of speculative attacks by short sellers. You’d also have to wonder why central banks bother to hold any assets at all. But if you think that asset backing determines money's value, there's nothing to explain. Money's value is governed by its backing, just like stocks, bonds, and every other financial security, and short selling will not affect its value.

Getting naked: in praise of naked short selling

Photo by Spencer Tunick, Netherlands 8 (Dream Amsterdam Foundation) 2007 [link]

If short sellers are considered to be the Mussolinis of the financial market, then naked short sellers are its Hitlers.

In this post I'll show that naked short selling isn't solely a hedge fund or equity market phenomenon. In fact, the good old fashioned practice of deposit banking amounts to what is essentially naked short selling, thus making staid bankers, and not hedge funds, the world's largest naked short sellers. This means that anyone who vilifies the naked short selling of equities must also be against the common practice of banking—a crack pot position if there ever was one.

Short selling is when an investor borrows shares of, say, Microsoft, then sells those shares in the open market. At some point—either at the lender's behest or the investor's—the borrower will repurchase the shares in the open market and return them to the lender. A short seller hopes that the price of Microsoft has declined in the interim so that when the time comes to repurchase them, it will cost less money, thus resulting in a profit to the short seller.

Naked short selling is similar in every respect save for one: when our investor sells Microsoft shares short in the open market, they do so without borrowing those shares ahead of time. (To get more specific, read this SEC page)

Which sounds odd, right? How can someone sell something if they haven't either purchased it or borrowed it ahead of time? No wonder people wrinkle there noses at the practice of naked shorting—it seem like sleight of hand!

The best way to think about naked short selling is to turn to banking. Why? Because bankers engage in short selling every.single.day. Just as an equity short seller will borrow and then sell Microsoft with the intention of repurchasing it at a better price, bankers borrow and then sell dollars with the intention of repurchasing them at a better price. Apart from the respective instruments involved, dollars vs stock, there's no difference between what an equity short seller and banker are doing.

So if bankers engage in short selling, do they act as mere regular shorts sellers or do they get naked?

In the previous paragraph you may have noticed that I described banking as the borrowing of depositors' dollars in order to lend those dollars out. Because the dollars were borrowed prior to sale, this would qualify their activity as regular short selling, not naked short selling.

But hold on, this isn't at all how banks function. Bankers don't wait for physical Federal Reserve dollars to be deposited by the public before selling them away—they short dollars whenever they wish, creating electronic deposits out of nothing in order to buy things like bonds or personal IOUs. Banks are engaged in naked shorting pure and simple: they sell a financial instrument that they never actually had in their possession.

How do they do this? The key here is that banks don't actually sell Fed paper dollars short, rather, they sell dollar-linked IOUs (i.e. deposits) short. A deposit is a claim on the bank's capital that mimics Fed paper dollars by being indexed, or denominated, in terms of those paper dollars. It's similar to a Fed dollar, but it's an entirely different instrument.

Circling back to naked equity short sellers, the same thing is occurring when a naked short is initiated. The instrument that they are selling short isn't a Microsoft share, but a newly-created IOU that is denominated in Microsoft shares. It would be as if I gave you scrap of paper with the words "I owe you one Microsoft share" on it. Rather than buy a real share, you could just hold the IOU I gave you. The instrument would look like a share, walk like a share, and even circulate alongside shares, however it would be an entirely new financial instrument.

This ability to "print" new IOUs denominated in terms of Federal Reserve dollars (in the case of the banker) or in terms of Microsoft shares (in the case of the short seller) often results in a quantity of derivative units that far exceeds the underlying issue of base units. We get an inverted triangle of sorts where on top of a narrow base of Fed paper dollars is arrayed a much larger quantity of dollar-denominated deposits, often 10 or 20 times more. Likewise, the number of Microsoft-denominated IOUs that naked short sellers create may eclipse the number of actual Microsoft shares outstanding.

It is the naked short seller's possession of a so-called printing press that draws the wrath of CEOs. The accusation is that a hedge fund can make a good profit by manufacturing and selling massive quantities of Microsoft-denominated IOUS in order to drive Microsoft's stock price down to zero, thus benefiting its short position. Emblematic of this belief is the battle waged by Overstock CEO Patrick Byrne against short sellers who had been engaging in naked selling of his firm's stock, which had fallen on hard times. As early as 2005, Byrne accused short sellers of creating a fake supply of Overstock shares (at one point reputably six times more than actual shares issued) in order to drive its price lower. Byrne went so far as to launch several lawsuits against the perpetrators.

How legitimate is Byrne's concern? Let's return to our bank analogy. Is there anyone who would argue that because banks can create and short deposits willy nilly, they'll drive down the underlying Fed dollar's price towards zero (ie. create hyperinflation) and thus earn outsized profits? Of course not. Banks in the U.S. and Canada have been creating deposits for centuries without causing hyperinflation. It simply isn't a concern because the issuer of underlying dollars, the Federal Reserve, stands ready to support the value of the dollars it has issued. It can provide this sort of anchor because it holds a variety of assets that can be mobilized to repurchase and cancel paper dollars, thereby removing any excess supply that might emerge thanks to competing issues of dollars by banks.

Likewise, if naked short selling creates a glut of Overstock IOUs and begins to drive down the price of Overstock, then in the same way that the Fed can deploy its assets to remove the supply of Fed dollars to stabilize their value, Overstock's Patrick Byrne could have used his firm's assets to repurchase stock. If he chose not too do a buy back, one might wonder if his company had the assets on hand to begin with.

To sum up, in the same way that bank issuance of dollar-denominate IOUs cannot drive the purchasing power of underlying Fed dollars down as long as the Fed has sufficient assets and chooses to use them, neither can naked short sellers drive Overstock prices down if the company has sufficient assets and is willing to conduct the necessary repurchases.

So haters of naked short selling, are you consistent in calling for an outright bank on banking? You say that naked shorting drives down stock prices, which means you no doubt also believe that banks inevitably create hyperinflation, right?

Addendum:
JKH has a post on the topic here, the Full Monty on Naked Short Selling.

A market for corporate votes

Berkshire Hathaway annual general meeting

When you purchase a share you're not only getting the opportunity to make some extra cash. You're also buying a vote. Put differently, a share offers two different features: a) a claim on earnings and b) the right to exercise partial control over the corporation.*

Why not separate the two features and put each of them up for sale? Let's have one market for corporate votes, and a separate one for corporate returns.

Here's how it would work. Imagine you want to buy some Microsoft shares but don't care to participate in the governance of Microsoft. The quoted price on the market, $44.93, is for a whole share of Microsoft, both its attached voting rights and its capitalized return. So you buy 500 whole shares for $27,465.

Next you turn to the parallel public voting market. Microsoft votes are trading for around 25 cents each, say. You 'detach' each of the 500 votes from the shares you've just bought and sell those votes for 25 cents each in the voting market for a combined $125. Not a bad day's work. In selling the votes that you never wanted anyways you've defrayed your initial purchase cost.

A few years later you decide to get out of Microsoft. One way is to find a set of buyers who, like yourself, don't care to vote, and sell the voteless shares directly to them. Alternatively you can repurchase the 500 votes in the voting market, reattach them to the shares, and sell them in the whole share market.

Here's another hypothetical: imagine that you have 500 shares of Microsoft but feel that it's your destiny to have a much more active role in Microsoft governance than your 500 votes would otherwise provide. Say you'd like ten times the votes, or 5,000 votes. To amass that quantity of votes it would normally cost you the price of 4,500 additional shares at $44.93 each, or about $207,000, but that's far out of your league. That's where the market for Microsoft votes comes in. For a mere $1125 you can pick up 4,500 detached votes, assuming they trade at 25 cents each. Without having stumped up too much capital, you've become a much more formidable shareholder activist.

So why have a market for corporate votes?

According to Broadridge, some 70% of retail shares go unvoted. Participation rates are better on the institutional front where some 90% of institutionally-owned shares are voted, but this is due to a legally-mandated fiduciary responsibility to vote. The responsibility for voting these shares is usually outsourced to a proxy advisory company like ISS which, according to one account, advised on over 50% of corporate votes cast in the world. ISS's success is due in part to the fact that institutional shareholders have scarce resources, most of which are ready allocated to searching for new investments and monitoring existing ones. They can't spare the cost of setting up expertise in corporate governance.

So to a large proportion of retail and institutional investors, votes represent little more than a nuisance. In order to play the stock market game, these investors hold their noses and pony up enough cash to buy a share and its combined vote; but they'd really be quite happy if they didn't have to buy the latter, especially if it meant reducing their overall costs.

If those who view votes as a nuisance comprise the sell side of the corporate vote market, then the buy side would be comprised of a cadre of institutional investors who specialize in corporate governance and shareholder activism. Activist investors, say someone like Bill Ackman, have developed expertise and a set of practices that allow them to efficiently put votes to work, instituting change in a company's structure or management in order to make it more profitable. They place a much higher marginal value on the votes attached to shares than the majority of their not-so-active colleagues.

A market in corporate shares would allow both the apathetic and the active to meet, with the final result being a more efficient allocation of returns and voting rights.

What I'm proposing may sound a bit sci fi, but what if I told you that such a thing already exists?

The fact is that we already have an informal market of sorts in corporate votes. In Canada, for instance, firms often issue both non-voting, voting shares, and multiple voting shares. In the U.S. the practice is less common, one example being Google which has issued 'A' shares with one vote apiece; 'B' shares with ten votes each; and 'C' shares with no votes. Or consider Warren Buffet's Berkshire Hathaway. An owner of $10,000 worth of Berkshire Class B shares has 0.15% of the votes that an owner of $10,000 worth of Class A shares has.

When companies have dual share structures, to buy votes, an investor need only short the non-voting shares in order to fund a long position in the voting class. And to sell votes, do the opposite. The cost one would incur on this transaction indicates the dollar value the market places on the right to vote.** Canadian readers may well remember that Mason Capital engaged in this strategy with Telus shares back in 2012 when it purchased Telus voting shares and shorted its non-voting shares.

But there's a more interesting way to get one's hands on extra votes. Start by borrowing whole shares just prior to a vote, much like a short seller borrows shares prior to selling them short. Rather than selling the borrowed shares, however, an activist holds them in order to exercise their voting rights, then returns the shares soon after the vote to the lender. The cost they'll pay on this round trip represents the price of a vote. From the perspective of the the owner who has lent the shares out, they require a high enough fee in order to compensate them for having foregone their franchise over the interim.

For instance, in 2002, Laxey Partners, a hedge fund, held about 1% of the shares of British Land, a major U.K. property company. However, on the day of British Land's shareholder meeting Laxey controlled 9% of the votes, note Hu and Black, all the better to support a proposal to dismember British Land. Just before the record date, Laxey had borrowed 8% of British Land's shares.

The term used for having more votes than shares is empty voting. Someone with 5,000 votes and only 500 shares is in possession of 4,500 empty votes, since those 4,500 votes have been 'emptied' of their economic interest. Empty voting is welfare-improving when an activist investor with a good plan acquires votes beyond his or her economic interest in order to ensure that their plan is adopted. However, at the extreme, empty voting can get downright spooky.  Consider a fund that has amassed short position in a stock (ie. it expects the shares to fall in value) while building a long position in votes. Perversely, this 'rogue' fund could very well use their franchise to implement changes that hurt the firm, not help it, and thereby bolster their short position.

Hu and Black, who refer to the decoupling of votes and economic interest as "the new vote buying", note that vote transactions are often hidden from the public and regulators. All the more reason to have a formal market for votes as described at the start of this post rather than the terribly confusing one that already exists. A transparent price for voting would help reveal rogue attempts to corral large empty voting positions. Those activists who truly want to create shareholder friendly changes would be able to accurately price out the cost of resisting the rogues.

And all those investors who are too unsophisticated to understand the murky world of stock lending, ie. retail investors, would be able to use widely-disseminated prices to better gauge the value of their vote and access an open market for the transferral of those votes.

---

* A share also offers a third feature, a liquidity return. I've pointed this out many times before. For the sake of this post, we'll ignore the liquidity portion.
** Strictly speaking, if the non-voting shares you short also happen to be less liquid than the voting shares you are long, then you are not only buying votes, you're also buying liquidity. But as I pointed out in the above bullet point, I'm ignoring liquidity returns for the sake of simplicity.
*** I have an ulterior motive for a market for corporate votes. I think the phenomenon of naked shorting doesn't deserve the vilification it receives in the press and on blogs. In fact, naked shorting is a necessary part of ensuring that liquidity premia on equities are kept at market clearing prices. The proper functioning of what I've referred to as the 'moneyness market' depends on naked shorting. The problem with a naked short is that the resulting synthetic security that the short seller creates doesn't have a vote. It is a non-standard instrument. With the existence of a corporate vote market, a naked short seller might re-standardize the instrument by purchasing a vote and attaching it to the IOU that they've created via their naked short. I do plan on writing about this next month, so if you didn't understand my point, just wait. 

Links:
Hu & Black, 2006. The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership
Aggarwal, Saffi, & Sturgess, 2010. Does Proxy Voting Affect the Supply and/or Demand for Securities Lending
Financial Post, November 2012. Empty Voting Clouds Shareholder Rights Law
Black, 2012. Equity Decoupling and Empty Voting: The Telus Zero-Premium Share Swap
Brav & Mathews, 2011. Empty voting and the efficiency of corporate governance

Short Squeezes, Bank Runs, and Liquidity Premiums

This is a guest post by Mike Sproul. Many of you may know Mike from his comments on this blog and other economics blogs. I first encountered Mike at the Mises.com website back in 2007 where he would eagerly debate ten or twenty angry Austrians at the same time. Mike was the first to make me wonder why central banks had assets at all. Here is Mike's website. 

On October 26, 2008, Porsche announced that it had raised its ownership stake in Volkswagen to 43%, at the same time that it had acquired options that could increase its stake by a further 31%, to a total ownership stake of 74%. The state of Lower Saxony already owned another 20% stake in VW, so Porsche's announcement meant that only 6% of VW's shares were in “free float”, that is, held by investors who might be interested in selling.

Porsche's buying had inflated the price of VW stock, and investors had been selling VW short, expecting that once Porsche's buying spree ended, VW shares would fall back to realistic levels. Short sellers had borrowed and sold 12.8% of VW’s outstanding stock, but with free float now down to 6%, short sellers owed more shares than were publicly available. If the lenders of those shares all at once demanded repayment of their shares, then there would be 12.8 buy orders for every 6 shares available. In what was called “the mother of all short squeezes” share price rose until the short sellers went broke.

A short squeeze is bad news for financial markets, largely because the fear of short squeezes deters short selling, and thus inhibits the normal arbitrage processes that keep securities correctly priced. If I may make a suggestion to the owners of the world's stock exchanges, there is a simple way to prevent short squeezes from happening on your exchange: Allow cash settlement of all short positions, just like in futures trading. If the most recent selling price of VW was 250 euros, and if short sellers suddenly find no shares available, then allow those short sellers to pay 250 euros in cash (plus some small penalty) to the lenders of the shares, rather than having to return an actual share of VW. This would prevent the stampede to buy VW, and would assure that VW’s price would not skyrocket to crazy levels. (As a measure of short-squeeze mis-pricing, it is worth noting that VW briefly became the world's most valuable company at the height of the short squeeze.)

Short squeezes on stock exchanges are mercifully rare. Unfortunately they are not quite as rare in the banking world, where they go by the name of bank runs. Just as a short squeeze pushes short sellers to hand over more shares of VW than can be obtained on the market, a bank run pushes banks to hand over more currency than can be obtained on the market. And just as short squeezes can be mitigated by allowing cash settlement, so can bank runs be mitigated by allowing banks to settle their obligations in forms other than currency. Clearinghouses and other banking associations can issue loan certificates or scrip for use in clearing checks, or even for public use as currency. Some creativity might be required in the issuance of money substitutes, but in return banks are spared from having to sell their assets at distress prices, while the community is spared from the effects of a bank panic.

What I find most interesting about short squeezes and bank runs is that they are a clear case of market failure, where financial instruments are obviously trading above the value of the assets backing them. During a short squeeze, value is no longer determined by backing, but by the forces of supply and demand. I don't think that economists pay enough attention to this point. The price of financial securities is normally determined by the underlying assets, while the price of commodities is determined by supply and demand. When economics textbooks explain supply and demand, they speak of the supply and demand for apples and oranges or other commodities. They rarely if ever speak of the supply and demand for stocks and bonds, because stocks and bonds are not objects of consumption, and they are not produced using scarce resources. There is no production function and no consumption function, hence there are no supply or demand curves. When we examine a bond that promises to pay $105 in 1 year, we find the price of that bond by dividing 105/(1+R). If R=5% and we tried to sketch supply and demand curves for that bond, we would draw a pair of meaningless curves that were both horizontal at $100. This is what makes short squeezes so strange. The price of VW stock is supposed to be determined by backing, and not by the supply and demand for VW shares. But during a squeeze, supply and demand take over, and stocks trade at a premium relative to their backing. The same might be true of money during a bank run.

This is a problem that JP and I have batted around a bit. I usually argue that arbitrage prevents money from trading at a premium relative to its backing, while JP usually argues that money can trade at a small premium. I can never pin him down on the size of the premium, but he doesn't argue much when I throw around a figure of 5%. Well, here we have VW stock trading at a premium of 500%. Might such a premium be possible for money?

Apparently not. We never see comparably large premiums on currency during bank runs. Gerald Dwyer and Alton Gilbert (Bank Runs and Private Remedies, May/June, 1989) examined American banking panics that occurred between 1857 and 1933, and found that the largest paper currency premium (relative to certified checks) ever observed during bank panics was 5%. The average paper currency premium during bank panics was much lower, only about 1%. Other measures of a currency premium, such as a rise in the value of money relative to goods in general (i.e., deflation), are also in the modest range of 1-5%. Why the enormous gap, from a 1% premium on currency to a 500% premium on VW stock? My best explanation is that banks can get creative in devising alternate forms of payment, while the traders in VW stock simply did not have the time or the legal means to devise alternate forms of payment. Thus the market in VW stock failed catastrophically, while banks facing a run are able to muddle through.

The result of the banks' muddling with money substitutes is that even during stressful events like bank runs, the value of money is, at most, only 5% higher than its fundamental backing value. This makes sense, because any premium over backing value gives an arbitrage opportunity to investors. If the fundamental backing value of each dollar is 1 oz. of silver, and if the dollar somehow trades at 1.05 oz., then the issuer of that dollar earned a free lunch of .05 oz. This free lunch would attract issuers of rival moneys, and rival moneys would keep being created until each dollar traded at its fundamental value of 1 oz.

The idea that money is worth no more than the assets backing it is consistent with finance theory, and with the backing theory of money, but it contradicts the quantity theory of money. The quantity theory asserts that modern fiat money has no backing, that it is not the liability of its issuer, and that its entire value is therefore a monetary premium. Which of the two theories gives a better fit to real-life moneys? When we look around for moneys that fit the quantity theory, that have no backing and are not anyone's liability, we find very little. Just bitcoin and a few orphaned currencies like the Iraqi Swiss Dinar. When we look around for moneys that fit the backing theory, that are the recognized liability of their issuer, and are backed by their issuer's assets, we find every other kind of paper and credit money that has ever existed. I conclude that the backing theory beats the quantity theory.

Shades of a liquidity premium peaking through in stock market prices

In my other life, I analyze the stock market. I always find it interesting when the stock market reveals its often hidden monetary nature. The common assumption is that monetary analysis should be confined to a narrow range of coins, dollar bills, central bank reserves, and bank deposits. But this ignores the fact that all valuable things in an economy have a degree of liquidity, including stocks.

A stock's price can be decomposed into a "fundamental" component and a liquidity component. Fundamental value arises from a stockholder's right to receive any distribution of the assets of a corporation. The liquidity component is the premium on top of fundamental value that arises from the owner's ability to easily sell that stock. Knowing that a stock can be easily sold provides the owner with a degree of comfort that would otherwise be lacking if the stock was less saleable, or not saleable at all. This "comforting service" is built into the stock's price as a liquidity premium.

While in theory we can determine a stock's monetary nature by subtracting its fundamental value from its price, in practice this is almost impossible to do. Computing fundamental value is more art than science. Nevertheless, we can get indirect evidence of the existence of a liquidity premium by comparing different share classes issued by the same company. In Canada, it's common for large family-owned corporations to issue non-voting and voting shares. The family controls the company by holding 51% of the voting shares while the public holds the balance of the voting and all the non-voting shares. Both voting and non-voting shares rank pari passu, meaning they receive the same claim on the company's assets.

Given these properties, we'd expect the market price of voting shares to be equal-to or greater-than the price of non-voting shares. After all, since everything else about the two classes is equal, having a vote can only add to the value of a share.

The chart below shows the voting and non-voting share price of a major publicly-traded Canadian retailer. Below the price is the premium/discount on the non-voting shares. At the bottom are relative volumes traded.

Now it's evident from the chart that our hypothesis doesn't hold. For long periods of time, the non-voting shares of our retailer have traded above the voting shares. What might explain this? One reason is that non-voting shares are far more liquid than the voting shares. Just look at the much higher trading volumes in the non-voting shares. From 2008 to 2010, shareholders valued the liquidity bonus of non-voting shares more highly than the element of corporate control provided by voting shares. In other words, the perceived benefits provided by the liquidity of the non-voting shares caused their liquidity premium to balloon to the extent that non-voting share prices rose above voting share prices.

Why doesn't the non-voting share premium get arbitraged away? Well, the comfort that liquidity provides is a very real service, not a mistaken bit of irrationality that can be ironed away. A highly-liquid share is like a fire extinguisher - even if it's not being used, just having it there makes you feel better. So while buying cheap voting shares and short-selling expensive non-voting shares may seem like a risk-free arbitrage, it isn't. After all, if the market decides to put an even higher value on the liquidity services provided by the non-voting shares, then non-voting's liquidity premium will grow even more and the trade will lose money.

While risk-free arbitrage can't shrink a stock's liquidity premium, there are indirect forces that ensure the premium stays thin. The larger a firm's liquidity premium, the lower its cost of capital. After all, if you need to raise money, having a larger liquidity premium means that you needn't issue as many shares. Because a low cost of capital is a boon, firms will try to replicate the success of competitors who have attracted a large liquidity premium. They may do so by pursuing similar lines of business or marketing their shares to the same group of shareholders. This will have the effect of drawing trading activity away from shares with large liquidity premiums to those without, thereby destroying the underpinnings of that large premium.

All of this plays into the ongoing bitcoin discussion between Mike Sproul and I. While Bitcoin might have some negligible fundamental, or non-monetary, value due to its value as a curio, its liquidity premium is surely huge. There is no way to arbitrage this premium away directly, but over time competitors will peck away at it, causing bitcoin's price to deteriorate back to its fundamental value, which I'd guess is <$1.

Almost everyone is (or has been) a short-seller

People often have difficulties wrapping their head around the idea of selling a stock short. It seems odd. Once people understand how it works, they also tend to perceive short-selling as immoral. They also assume that only a few malcontents engage in that sort of transaction.

But everyone either has been, is, or will be a short-seller.

When you short a stock, you're basically borrowing a stock and immediately selling it in the market. When the lender of the stock demands the stock back, as the short seller you've got to buy the stock back in the open market and deliver it to the lender.

Now consider someone who borrows from the bank. You borrow a deposit and immediately sell it in the market. When the bank demands the deposit back, as the borrower you have to buy the deposit back in the open market and deliver it to the bank.

These two transactions are the same transaction. Borrow an asset, sell it, and when the lender requires delivery, buy it back and deliver it to the lender. Anyone who borrows from a bank is a short-seller.

Part of the ethical argument against short selling has been that short sellers are hoping for lower stock prices. The reason short sellers want a stock's price to fall is that it allows them to buy the stock back at a cheaper price and deliver it to the lender of the stock, thereby earning a good profit. Wishing for a lower stock price is presumably the unethical part. It's a form of schadenfreude.

But anyone who borrows from a bank wishes for the very much the same thing! When the bank calls in your loan, you really hope that those deposits have fallen in value. That way you earn a profit. You earn a profit because you don't have to sell as many real resources to repurchase the deposits as you initially bought with the first sale of deposits. There's also schadenfreude involved here. Wouldn't you prefer if the bank had gone belly-up? Or that your nation's central bank had gone hyper-inflationary? Either way, buying back the deposits will be a cinch.

So if short selling is only done by vultures, so is borrowing. If the former should be banned, so should the latter.