7 April 2021

Short selling is the market’s way of preventing failures like Greensill

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This contretemps over Sanjeev Gupta, his companies in the Liberty Alliance and Greensill Capital, is excellent evidence for why we must allow short selling in financial markets. Precisely because the ability to profit from finding those abusing the system provides the incentive to do so.

Just to recap the situation so far: Greensill pioneered the use of “reverse invoice factoring”, an entirely sound financial technique. Lend people the money to buy their supplies and collect when they sell their product – and why not? The cash for this came from creating short term bonds and notes held in a fund at Credit Suisse. Those notes backed, of course, by trade creditor insurance. That being where the process started to fail: the insurance was withdrawn, the notes then became due and – well, and it collapsed.

Greensill found they’d made the classic mistake that Adam Smith warned about those 245 years ago:

If the legal rate of interest in Great Britain, for example, was fixed so high as 8 or 10%, the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone would be willing to give this high interest.

As we can and probably should put it, those most eager to borrow money either at high interest or in new and interesting ways are precisely those people we don’t want to be lending money to. Among them Sanjeev Gupta and his Liberty Alliance.

The basic plan was to cobble together a metals giant out of the scrag ends of businesses that everyone else was dumping. This could work, it worked in the 1990s for Lakshmi Mittal after all. The difference appearing to be that Mittal made it work and Gupta hasn’t.

That is all just background. The point here is that – excepting those bonds – all of this was happening in unquoted stocks and companies. There was no way for anyone who thought it wouldn’t work to bet against it doing so. It was possible to not invest in the bonds, sure, but no money could be made by investigating the system fully and testing it to see if it really did, or even was likely, to work.

That is where the value of short selling comes in – it provides the incentive to do that research. The Prime Minister has said that “greed and capitalism” work. Eamonn Butler prefers the idea of “enlightened self-interest”. My own formulation is that greed is not universal but it is a human constant – the genius of capitalism is that it tames that greed into enlightened self-interest.

In the open market anyone slightly worried about Liberty Alliance’s soundness would simply not get involved. If short selling were possible there would be that incentive to do the investigation. As, say, Citron did with SinoForest. As others did with Wirecard.

Markets are informationally efficient, but they are more so when they are complete. That is, when it is possible to bet, or invest, downwards as well as up. To be able to profit from a negative view of a situation as well as a positive one. This is why Nobel-prize winning economist Robert Shiller proposed that we need to be able to short housing to prevent another bubble of the sort the precipitated the 2008 financial crisis. Going short on the housing finance, as was eventually done, works but not quite as early. With Greensill, the wheels did eventually come off, but if either or both Greensill and Liberty were publicly quoted stocks there would have been more work done on their fiscal worth at an earlier stage and that information would have been reflected in the value of those stocks.

There’s nothing about this current mess which makes us desire less investigation of the likely success of the plan now, is there? I am certain that it wouldn’t have got this far if either or both companies had been publicly listed.

It’s not that public markets necessarily insist upon greater visibility or transparency – as Wirecard showed – but that short selling allows those interested to express their views. Views formed by the incentive to be able to profit from having done the work to form one.

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Tim Worstall works for the Continental Telegraph and the Adam Smith Institute.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.