Arshad Shaikh discusses the ethical aspect of short selling in the stock market. The spectacular collapse in the market capitalisation of the Adani Empire after the publication of a report by Hindenburg Research, exposing the group’s alleged malpractices put the spotlight on the practice of short selling in the equity market as Hindenburg is a self-confessed short seller. However, the current debate on the Adani-Hindenburg story is confined to the intentions of the report (how it is a conspiracy to belittle India’s growth story), the role of regulators and short sellers in the market and the alleged proximity of Adani with those in the highest echelons of power. The process of short selling cannot operate without recourse to a methodology that is speculative and akin to gambling and wagering. These speculative instruments are extremely complex and difficult to understand. They were the main culprits that ruined the global economy during the 2008 financial crisis but unfortunately little was done to expose and resist their reign of terror. The world must neutralise this evil if it wants economic stability and bid adieu to market crashes and financial meltdowns.
When New York-based investment research firm Hindenburg Research published a report -“Adani Group: How the World’s 3rd Richest Man Is Pulling The Largest Con In Corporate History”, little did anyone imagine that it would wipe out more than $100 billion off the market cap of the Adani Empire and shake the very foundations of India Inc on the global arena.
According to Hindenburg, the Adani Group engaged in “a brazen stock manipulation and accounting fraud scheme over the course of decades.” The Adani Group dismissed the charges as a bunch of lies and responded by terming the exposé as a conspiracy against India’s growth story. It asserted that the fundamentals of the conglomerate were sound, their accounting standards were impeccable and the company never indulged in anything illegal.
Hindenburg Research is an activist short seller and was accused by the Adanis to have mala fide intentions and a vested interest in such muckraking. The media debate after the market crash in Adani shares hovered around the role of regulators and safeguarding the investment community from such events. As the Adani Group is supposedly close to the current establishment, many saw the Hindenburg report as an indictment of the government that allegedly played a pivotal role in the phenomenal rise of the Adanis.
The role of short sellers and their utility in the stock market was also highlighted. However, the moral dimension of the entire saga was missed out completely. It is important to delve into the process of short selling and diagnose it against the universally accepted standards of ethics and fair play.
It is a well-documented fact that the 2008 financial crisis was aided and abetted by banks who were engaged in hedge fund trading with speculative financial instruments like derivatives. The role of short sellers in a financial crisis is highly debatable as many say they are responsible for driving down the price of securities or at least exacerbating their rapid decline.
THE PROCESS OF SHORT SELLING
Shares of companies are traded (bought and sold) in a stock exchange or the “share bazaar”. The most common trading strategy is called “playing long”. It means you purchase shares at a particular price and wait for their market value to appreciate. If the price of the shares you possess increases, you sell them at a profit. This means that you only win if the price of your share moves up.
The other trading strategy is “playing short” or short selling. Here the trader profits when the price of the stock plummets. Hindenburg Research (also a short seller) is supposed to have made millions when the Adani shares fell. But, how is this done?
How can one profit when the value of his stock decreases? The answer lies in the process of short selling. For short selling, you borrow shares from a broker or dealer. You pay a certain rent (fees/interest) for those borrowed shares. However, bear in mind that the shares borrowed have to be returned to the broker. You are permitted to sell the borrowed shares in the market, the proceeds of which are credited to your account.
But, what about the promise to return the borrowed shares? You must return the shares to the broker. If the price of the share reduces during the time you borrowed them and returned it to the broker, you make a profit. You pocket the difference between the price at which you sold the borrowed shares and repurchased them at a lower price. Thus, your trade is profitable if and only if the share prices of the selected company fall. If they do not, you may lose an indefinite amount of money.
The current debate surrounding short selling is all about its role in the market. Some say it is a “necessary evil”, which bursts the pricing bubble around the shares of certain companies. It kills overvalued and artificially inflated stock and helps investors. Others feel that short sellers target companies they despise and conspire to destroy their market capitalisation. However, among this discussion on the role of short sellers in the market, what is conveniently forgotten is the completely flawed and unethical process of short selling.
In the real world, to sell a borrowed asset is an undeniable crime. As a property owner, will you allow your tenant to sell your apartment with or without your knowledge? Will the law permit such a trade? Analogically, this is exactly what a short seller does.
Moreover, the tenant returns the borrowed asset at a price that is currently prevalent in the market and not at the original price borrowed. Will any bank or moneylender follow this principle? Will a bank allow the lender to return an amount that is significantly less (accounting for inflation, etc.) compared to the original sum borrowed?
In the case of goods trading, the supplier (wholesaler/manufacturer) sells his products to the retailer/shopkeeper on “terms credit or cash”. Sometimes, the retailer simply offers space for the products and pockets a cut for that “retail space”. Short selling is completely unnatural and against all norms of ethical trading.
The problem with the world of conventional finance is that it is founded on principles that would be unacceptable in the real world. Take the case of charging interest on loans. The entire edifice of the banking industry rests on it. Those who rule the world of finance devise rules that enable them to make money from money. They have financial instruments that hedge them against risks. The prescription is – heads I win tails you lose. An entire portfolio of speculative financial products is continuously dished out.
Financial innovation is the name of the game. Forwards, Futures, Options and Swaps are all derivative products designed to ensure “transaction security”. A system of trade, which benefits only one party unilaterally, is unjust and unfair. The Prophet Muhammad ﷺ said: “It is not permissible to sell something that is not with you, nor to profit from what you do not possess.” (Ibn Majah) This single command blocks all the roads to speculative trading and ensures a market based on fundamentals and ground reality.
Michael Hudson correctly defined a derivative as “a bet on whether a stock or a bond or a real estate asset, is going to go up or down. There’s a winner and a loser. It’s like betting on a horserace.” The world will continue to suffer economic instability until finance is cleansed of speculation and its unethical processes. Until then, betting on a horserace will continue.