Thursday, September 18, 2008

Free Markets Don't Wear Shorts

The last post ended with the strange assertion that the practice of shorting would not exist in a truly free market.

A large number of pundits are using free market style rhetoric to support unrestricted trading of derivatives. My assertion is that the current mix of derivatives offered by the market are a creation of a regulatory regime. A truly free market would have a different mix of trading tools created by the owners of the assets traded.

Stock is a contract that allows joint ownership of a company. In an unregulated market, the people making the contract would spell out the rights entailed in the ownership of the contract.

I contend that the self interested parties writing the contracts would disallow the practice of shorting. Lending the stock to shorts causes an overall devaluation of the company. This is against the interest of the people selling the asset. Shorting also creates confusing ownership issues with both the person who lent their shares to shorts and the person who bought the borrowed shares behaving as if they owned stock.

With unregulated shorts, a person could buy a thousand shares. Short that thousand shares and buy another thouand shares. They could then claim to have twice the ownership rights in a company than their actual exposure to risk.

Practices that confuse or multiply ownership are not in the interest of the parties selling joint ownership of an asset.

Anyone who believes that shorting is a natural right, and that investors should be able to sell short with zero regulation must accept the practice of businesses shorting their own stock. In this case, you would see companies taking massive short positions to remove the positions from the market in an effort to protect their prime investors.

The logical trap we are in is that shorts were a creation of a regulatory regime. So, arguing for unregulated use of tools designed to regulate the market leads to logical paradoxes (a company shorting itself and confused ownership) and ultimately to a nihilistic behavior in the market.

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