Muddy Waters’ Answers to ESMA’s Consultation on the European Short Selling Regime

Muddy Waters Capital LLC has recently answered the European Securities and Markets Authority’s (ESMA’s) consultation on the review of certain aspects of the EU Regulation on short selling and made its answers available in a paper summing up ESMA’s analysis and answering its questions. We show in our answer to ESMA’s Question 1 that ESMA’s analysis of short selling and its impact on financial markets reflects important misunderstandings in three main respects.

First, short selling does not amplify economic and financial crises. To the contrary, the preponderance of passive holders in the floats of many stocks has created significant fragility, causing the risk of a price-crash with the magnitude of 1929 but at 2020 Covid dislocation speed. Given that active investors play a much smaller relative role in the modern market, restricting short selling during periods of dislocation can be self-defeating by removing a reliable bid that could establish higher floor prices.

Second, short squeezes are not a justification to increase regulation of short selling. Short selling is a niche strategy, practiced by a small fraction of equity market participants. Due to the asymmetrical nature of potential losses versus profits, it is inherently risky. It is not news to short sellers that squeezes can occur. Short selling requires a strong ability to manage risk, including the risk of squeezes. Rather than taking a paternalistic view toward short sellers by seeking to protect them from squeezes, ESMA should understand that short sellers acknowledge and accept these risks.

Third, measures seeking to limit short selling activity lack any serious theoretical or empirical underpinning. We do not believe that ESMA has ever proven the existence of a problem that its short selling regulation is intended to address. No serious study to date has substantiated the fears expressed by ESMA toward the supposed negative impact of short selling on the smooth operation of financial markets.

Our answers to ESMA’s subsequent questions are the direct consequence of this analysis. Many of ESMA’s questions focus on technical aspects of the Short Selling Regulation without addressing the main problems posed by this regulation. Question 3, for instance, enquires into the specific circumstances under which member states can ban short selling to address systemic risk despite these measures being per se a counterproductive answer to this risk. This exceptional power granted to national market authorities is all the more dangerous in that national authorities have discretion to ban short selling without properly demonstrating how bans are actually useful in preventing systemic risk. The German BaFin, for instance, decided to ban short sales of Wirecard’s shares for two months. This long-lasting ban has been extremely costly for short sellers, who had been trying to get BaFin to take their concerns about Wirecard seriously. The complete absence of evidence justifying the ban has demonstrated how problematic this can be. The ease with which Wirecard manipulated BaFin into seeking this ban should also give ESMA pause.

Likewise, the risk presented by naked short sales, which ESMA seeks to address in Questions 9 to 11, tends to be greatly overstated. It is entirely inappropriate for ESMA to speculate without any evidence that excessive naked short selling could have occurred in the case of GameStop, especially since the SEC itself underlined that these fears were largely unjustified.

ESMA often seems to worry about risks with no tangible substance. Before asking Question 12, for instance, ESMA outlines the risk of ‘abusive behavior’ and of the ‘creation of disorderly trading conditions for the EU market.’ We don’t understand what ESMA means by that. Assuming ESMA refers to the risk of market manipulation, one needs to bear in mind that market manipulation through short sales isn’t likelier than manipulation through long positions and that the Market Abuse Regulation already deals with this sort of issue. In any case, the concern expressed by ESMA about the risk posed by short selling seems purely hypothetical and isn’t substantiated by any concrete illustration.

ESMA doesn’t ignore the existence of scientific literature relating to short selling. It even acknowledges how unfavourable to existing short selling rules this literature is, which makes its analysis of these rules all the more surprising. We are nevertheless grateful to ESMA to have initiated this discussion about the Short Selling Regulation, which was long overdue, and hope to contribute by our answers to the improvement of the existing regime.

Carson Block is the founder and chief investment officer of Muddy Waters Research.