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Policy Tensor's avatar

Short sellers are crucial to the functioning of transatlantic finance. The reason is that we have a system where the marginal investor is a market-based intermediary — broker-dealers above all, but also hedge funds, large portfolio managers, and other risk arbitrageurs, along with real money investors like pension funds and endowments. The problem is that almost all of these marginal investors have a long bias. Broker-dealer banking firms are not only involved in market-neutral market-making, but also intermediate between money markets and capital markets by borrowing short and lending long. Their balance sheet positions are thus, under normal conditions, leveraged bets on the market going up. Most institutional investors, both large-scale portfolio managers like Blackrock and real money investors like CalPERS have largely long-only portfolios. Even most hedge funds make their money from at most market-neutral risk arbitrage strategies. Meanwhile, retail investors are almost always long. The short-sellers are the only ones in the business of keeping everyone honest through fundamental research. One can endogenize the capital allocated to short selling strategies in the manner that Shin et al. endogenize arbitrage capital (ie the folks holding dry power to buy up distressed illiquid assets like private equity and vulture funds). If you think along those lines, you can see how useful short-selling is to price discovery in a financial system dominated by long-biased financial intermediaries.

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BRENT BUTLER's avatar

You left out one item that I often hear short sellers themselves claim as a benefit: it provides an incentive for investors to find fraud. Enron is a poster child of this.

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