Quick Note: A best-of holiday edition today, chosen as a reminder that short sellers are good, contra to what a Los Angeles jury might have you believe. First run in December 2024, the text has been updated to reflect Cape Verde’s 0-0 win over Spain this week.

What the world needs now: More short sellers

In European tournament football (aka soccer), goals scored by the visiting team used to count for 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 (the total over two games, home and away), the tiebreaker was determined by whoever scored the most away goals, because scoring away goals is harder.  

It’s 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. Like away goals, they should 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 capped at 100% while losses are unlimited (the opposite of being long).

Those hard earned profits are more valuable than the easy profits from longs. Short sellers, in pursuit of their own profit, provide a service to the entire market: they uncover corporate fraud. 

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

Short sellers can. Shorting a stock and then publishing a report telling everyone why you think it should go down is the business model that helps keep finance honest.

The business model has made short sellers unpopular, I guess because it seems somehow unethical.

But shorting first and issuing a negative report second is no different than buying first and issuing a positive one. Everyone does this and no one has a problem with it.

Short sellers are nevertheless portrayed as greedy 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.

Their success is measured in dollars, of course, but money is often beside the point. Short sellers belong to a category of people who are drawn to risk for reasons that transcend financial reward. Nate Silver notes that “successful risk takers are not motivated by money. They live on the edge because it's their way of life.”

Short sellers live on the edge, 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 he found long investing to be “just about making money.” Activist short selling, by contrast, 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. 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, I agree.

There are more recent examples of short sellers’ heroism, too.

Short reports issued by Hindenburg Research led to the conviction of Nikola co-founder Trevor Milton on charges of securities fraud, exposed Tingo Group as “a massive fraud,” and raised questions about accounting practices at high-flying Super Micro Computer. All to the benefit of investors who might otherwise have invested in them.

It's not just investors who have benefited from the work of short sellers — corporations have 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 spared GM both the $2 billion it intended to invest and incalculable reputational damage.

For every corporate fraud exposed by short sellers, however, many more go undetected. So we need much more short selling.

Unfortunately, we’re not likely to get it. 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 precipitated it.

I agree that we should be hunting down whoever that was — so we can give them a reward. Maybe a parade, even.

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?

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. A worthy pursuit, but not much help to forward-looking investors.

Short sellers, by contrast, are real-time financial detectives doing the work that law enforcement and government agencies never could. And a financial “fourth estate” doing the investigative work that the modern media can no longer afford.  

Short selling therefore creates positive externalities that deserve to be encouraged — perhaps by making the profits from selling short count for more than the profits from buying long.

So here’s my policy proposal to encourage more, better financial investigation: make the profits on short selling tax-free.

Europe scrapped the away-goal rule in 2021 because it was encouraging home teams to play defensively and defensive football is boring to watch (unless it’s Cape Verde).

But playing defense in financial markets? That’s a good thing and not at all boring.

We should help short sellers do more of it.

— Byron Gilliam