Are Short Sellers Really 'Icky And Un-American'?

Last week, NYSE president Tom Farley took a personal shot at short sellers when calling for new rules to require them to publicly reveal their positions. Short sellers profit when share prices fall, but they are not currently required to disclose their bearish bets, allowing them to operate mostly under-the-radar.

It feels kind of icky and un-American, betting against a company, Farley said this week.

Farley is not alone in his calls for more transparency. Nasdaq Inc (NASDAQ:NDAQ) CEO Adena Friedman recently called for similar changes.

The company should be aware of who holds the long and short positions, Friedman said. Long investors are already required to publicly disclose their positions.

Transparency And A Healthy Free Market

Dennis Dick, proprietary trader at Bright Trading LLC and co-host of Benzingas PreMarket Prep show, says Farleys icky and un-American comment was taken out of context by the media. While short selling rubs many people the wrong way, Dick says it is a critical part of a healthy free market.

Short sellers are vital to price discovery. They keep prices in check and in line. Arbitrageurs, and market participants employing other types of statistical arbitrage strategies will keep relative prices in line by selling short the over-valued stock and buying the cheaper stock, Dick said.

Related Link: 9 Most Shorted ETFs In The Market

In addition, short sellers provide critical market liquidity during times of extreme volatility. When regulators limit short-selling, it can have extremely adverse consequences. Dick says an example of this type of regulation is the alternative uptick rule, which only allows short sellers to sell short a security that is down more than 10 percent above the current bid price.

ETFs, Volatility And The Alternative Uptick Rule

During the flash crash in August 2015, Dick says the extreme volatility in many ETFs was due to the alternative uptick rule.

Many ETFs fell as much as 50 percent in early trade before quickly recovering. If the alternative uptick rule had not been employed, those crashes would have been less severe. This is because arbitrage traders will buy the ETFs and short the underlying basket of stocks that make up the ETF, Dick said.

Theres a simple explanation for why many of the ETFs were down as much as 50 percent, despite underlying stocks being down only 10 percent, Dick says.

With the alternative uptick rule in place (and the volatility pauses), arbitrageurs could not get short the underlying stocks and therefore could not bid the ETFs.

What Does History Have To Say?

Other past attempts by regulators to limit market volatility by restricting short selling have had lackluster results as well. Back in 2008, the Securities and Exchange Commission attempted to stop the steep decline in the financial sector during the financial crisis by temporarily banning short selling of financial stocks from September 18 to October 8. During that time, shares of Bank of America Corp (NYSE:BAC), Morgan Stanley (NYSE:MS), Bank of New York Mellon Corp (NYSE:BK) and others plummeted more than 20 percent.

Farleys comments taken in any context reflect the views of a large number of investors who dont like the idea of profiting on the misfortune of other investors. But others argue that short selling plays a vital role in a free, efficient market. For now, at least, Farley and others arent calling for restrictions on short selling, but simply more disclosure and transparency.

Joel Elconin contributed to this article.

2017 Benzinga does not provide investment advice. All rights reserved.