Thursday, 2 April 2009

Shorting, market efficiency etc

Hat-tip to Zedman for pointing me in the direction of the IOSCO consultation (PDF) on the regulatory response in respect of short-selling. As he pointed out, IOSCO is basically positive about the role of shorting. This from the intro:
The Technical Committee believes that short selling plays an important role in the market for a variety of reasons, such as providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities.

I admit my ignorance here, and I'm seriously considering buying a serious text book to get my head around such things, but I don't think I can share some of these views. As I've said before I'm broadly neutral about the impact of shorting, but the argument that it has benefits bothers me.

We have had market bubbles since shorting has become more widespread - so can we assert that it mitigates them? The academic evidence on the impact of shorting in this regard is mixed from my limited reading of it. In what sense does it aid market efficiency? This seems to rest on the assumption that markets are efficient in the first place, and even so they may only be informationally efficient and only in a limted sense (ie information is factored into price quickly, but it could still be the wrong information). Surely even the EMH allows that prices at a given time may not represent a realistic view of the future, so this 'effiency' might simply mean getting it wrong sooner.

Finally the term 'price discovery' is one of those (like 'portable alpha') that really grates with me. In practical usage it seems to actually mean price formation, and the semantics are important. 'Discovery' implies that something is there to be found - there is a fundamental truth to be uncovered - but 'formation' is more accurate IMO because it suggests that price is the aggregate of market exchanges and the views implicit in them. I don't accept that shorting is better than other trading in terms of price formation - I don't see why it would be unless shorters are somehow inherently more rational or more informed than others. And I don't accept that there is a correct price to be 'discovered'.

To finish up here's a nice quote from Benoit Mandelbrot that expresses my scepticism more eloquently than I can -
"Value is a touchstone to most people. Financial analysts try to estimate it, as they study a company's books. They calculate a break-up value, a discounted cash-flow value, a market value. Economists try to model it, as they forecast growth... All this implies that value is somehow a single number that is a rational, solveable function of information. Given a certain set of information about an asset - a stock, a bond, or a pair of wooden culottes - everybody if equally well-placed to act will deduce it has a certain value; they will all hang the same price tag on it. Prices can fluctuate around that value; and it can be hard to calculate. But value, there is. It is a mean, an average, something certain in a chaos of conflicting information. People like the comfort of such thinking. There is something in the human condition that abhors uncertainty, unevenness, unpredictability. People like an average to hold onto, a target to aim at - even if it is a moving target."
The (Mis)Behaviour of Markets, B Mandlebrot, 2004

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