Still at it

Tweet According to yesterday's Sunday Times, 3.5% of the market value of FTSE100 companies has been lent to hedge funds to be short sold in an enormous bet that share prices will be falling. It's not as high as the 5% which was on loan during the financial crisis in June 2008, but it's still an awful lot of shares.

The short-selling game means that the hedge funds who have borrowed the shares sell them for one price and then buy them back at a lower price before returning them to their rightful owners, and pocketing the profit. Well, actually, they profit most of the profit; part of it goes to the Conservative Party, and part gets paid to the people who loaned them the shares in the first place.

But if they've made a profit, who's made the corresponding loss? After all, when it comes to share-trading, every profit must be balanced by a loss somewhere. The answer is that the owners of the shares – often pension funds, which effectively means an awful lot of us - have made the loss; they loaned the shares when they were valued at one level, only to get them back when the price has fallen. The total value of their assets has fallen by the difference.

Well, not quite. Because the hedge funds have paid them a small 'rent'; a share of the profit for the loan of the shares. So their loss is less than it would have been if they hadn't loaned the shares out. From their point of view, it's an apparently rational decision, because if the price was going down anyway, then they may as well mitigate the loss by taking at least a share of the profit made by the short-sellers.

But the really big question is whether the price would really have fallen anyway - to what extent are short-sellers simply betting on something that would happen anyway, and to what extent is the volume of selling which they do actually influencing the price on which they are betting? The greater the volume of shares that they can sell, the greater the influence they have on the outcome.

If they are influencing the price by their selling, then the action of those who lend them the shares to sell becomes a great deal less rational; they are then, after all, creating the loss which they are seeking to mitigate. They'd still do it though, for the simple reason that if others do it and they don't, then they still get hit by the losses but have none of the mitigation, and that affects their overall financial performance.

The practice is crazy when it's just betting; but it's insane if the people creating the losses are doing so deliberately purely because everyone else is doing it, and they can't afford to be left out. It's more Prisoner's Dilemma than roulette. 3.5% sounds like a small proportion, but it's enough to drive prices rather than simply bet on them.

Short-selling does not create wealth – it simply redistributes wealth from the many to the few. It should be outlawed.