Cryptocurrency is a young market. This means that this is a market where the value has yet to be discovered, and the dominant view on the cryptomarkets is one that supports the beliefs of a revolutionary idea that will transform the world for the better. What characterizes the crypto market specifically is that its audience is one with extremely strong convictions about the longevity of its market, and defends their beliefs with a strong passion. This results in a strong sentiment that is fundamentally bullish. So betting against the market going up, but instead going down is generally seen as treacherous, and those who do are being classed as a danger to the markets.
The truth however is that short selling plays an important role in efficient capital markets, conferring positive benefits by facilitating secondary market trading of securities through improved price discovery and liquidity, while also positively impacting corporate governance and, ultimately, the real economy. However, short selling and short sellers have received negative attention over the years, primarily due to general concerns that short selling is purely speculative and potentially destabilizing for markets.
Market benefits of short selling
Short selling contributes to the accuracy and efficiency of prices in securities markets, primarily by ensuring that both positive and negative public information about firms and assets are promptly reflected in prices. If short selling would be absent then there would be a permanent upward bias, which would not completely reflect the underlying fundamentals of an asset.
Let’s use an analogy of voting, a concept not unknown to cryptocurrency. If voting on a referendum for example is unconstrained i.e. voters can either vote “yes” or “ no”, then an unbiased result can be achieved. However, if a voter is constrained to voting either “yes”, then a permanent upward bias on the results would emerge.
Absent a short selling mechanism, security prices would face an upward bias and would not completely reflect a security’s underlying fundamentals. Diamond and Verrecchia (1987) offer a voting analogy to illustrate this bias.14 If voting on a referendum is unconstrained, i.e. voters can either vote “yes” or “no,” then an unbiased result is achieved. However, if a voter is constrained to voting either “yes” or otherwise abstaining entirely, then an upward bias on the results would be introduced in favor of “yes” voters. This causes problems, as this would neglect the concept of a “free market”, making it impossible for price to reflect underlying fundamentals, something the majority of Bitcoin believers strongly advocate for.
Short selling also positively impacts overall market quality, as it provides a healthy mechanism in which price can fluctuate as it finds value. If short selling were restricted in an asset, informed short sellers would be prevented from trading on negative fundamental information. Another problem is that the upside potential of price appreciation would be limited, as it would mean there will be a point that everybody eventually would be invested with a long bias. If one would start to take profits, in other words selling their positions, there would be no liquidity available to stabilize the price, and the asset could easily get caught up in a downward death-spiral, with no liquidity available to find a place of finding new value. It would be a one-way train ticket to 0.
Lastly, a great benefit of being able to position in a short, is that it offers a mechanic to protect investments from downward movements. If one has invested with an upwards bias, then shorting can help offset the exposure to the market on the long side. In case of a depreciative market, short selling can help to limit the losses by shorting or “hedging” against one’s own investment, so that capital can be maintained, and money made on the offset position to be reused in a future investment campaign.
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