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Asset Management Best Practice

The Role of Short Sellers in the Marketplace

by Raj Gupta

Executive Summary

  • This article examines the role of short-sellers in the marketplace. The process of short-selling involves three major participant groups: the lenders, the agent intermediaries, and the borrowers.

  • First, the history of short-selling is discussed briefly. This includes the enactment of the Securities Exchange Act of 1934, the adoption of the uptick rule following concentrated short-selling in 1937, and the relaxation of that rule in 2007.

  • Next, the short-sale process is discussed. Five categories of short positions are identified. These categories include general collateral, reduced rebate, reduced rebate and fail, fail only, and buy-in.

  • Third, the borrowers are identified and their activities are discussed. These borrowers include hedge funds, mutual funds, ETF counterparties, and option market-makers.

  • Fourth, the lenders are identified and their motivations for lending are discussed. The primary lenders include mutual funds and pension funds.

  • Fifth, historical statistics on the universe of lendable securities and the percentage of loaned equities are presented. A dramatic increase in the level of loaned securities is observed for the period 2006 to the second quarter of 2008 followed by significant declines in the third and fourth quarters of 2008. Since then, the level of loaned securities has gradually increased by 12%.

  • Finally a brief review of the academic literature on short-selling is conducted.


The term “short-selling” or “shorting” is used to describe the process of selling financial instruments (such as equities or futures) that the seller or holder does not actually own but borrows from various sources. If the value of the instrument declines, the short-seller can repurchase the instrument at a lower price and cover the loan. Short-sellers have long played the crucial role of price discovery in financial markets. If short-selling were not allowed, traders with negative views of certain stocks would at best avoid those stocks. However, short-selling allows them to generate returns based on their views if they are correct, hence making short-selling an important aspect in price discovery. Companies in certain countries where short-selling is not allowed may also list on the exchanges of countries where it is allowed. After the crash of 1929, the US Congress created the Securities and Exchange Commission (SEC) by enacting the Securities Exchange Act of 1934. Following an inquiry into the effects of concentrated short-selling during the market break of 1937, the SEC adopted Rule 10a-1. Rule 10a-1(a)(1) stated that, subject to certain exceptions, a listed security may be sold short:

  • at a price above the price at which the immediately preceding sale was effected (“plus tick”); or

  • at the last sale price if it is higher than the last different price (“zero-plus tick”).

This implied that short sales were not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. The operation of these provisions was commonly described as the “tick test.” Both the New York Stock Exchange (NYSE) and the American Stock Exchange (Amex) had elected to use the prices of trades on their own floors for the tick test. In 2007, the Commission voted to adopt amendments to Rule 10a-1 and Regulation SHO that removed Rule 10a-1 as well as any short sale price test of any self-regulatory organization (SRO). In addition, the amendments prohibited any SRO from having a price test. The amendments included a technical amendment to Rule 200(g) of Regulation SHO that removed the “short-exempt” marking requirement of that rule.

On July 15, 2008, the SEC issued an emergency order related to short-selling securities of 19 substantial financial firms,1 which took effect July 21, 2008. This order stated that any person executing a short sale in the publicly traded securities of 19 financial firms, using the means or instrumentalities of interstate commerce, must borrow or arrange to borrow the security or otherwise have the security available to borrow in its inventory prior to executing the short sale. On September 19, 2008, the SEC, acting in concert with the UK Financial Services Authority, took temporary emergency action2 to prohibit short-selling in 799 financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. This ban was lifted on October 8, 2008.

In this article we will examine the role of short-sellers. The profile of short-sellers includes hedge funds and other speculators, proprietary desks of bank holding companies, options market-makers, and, in recent years, mutual funds that execute 1X0/X0 strategies. We will discuss the academic literature on short sales, illustrate the short-sale process, examine the role of various participants in the process including lenders such as mutual funds and pension funds, agent intermediaries such as prime brokers, and borrowers such as hedge funds, mutual funds, and options market-makers, and we will present statistics on the universe of lendable and loaned securities. We find that the level of securities loaned versus the total universe of lendable securities increased dramatically during the period 2006 to the second quarter of 2008, followed by significant declines in the third and fourth quarters of 2008.

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Further reading


  • Boehmer, Ekkehart, Charles M. Jones, and Xiaoyan Zhang. “Which shorts are informed?” Journal of Finance 63:2 (April 2008): 491–527. Online at:
  • Brent, Averil, Dale Morse and E. Kay Stice. “Short interest: Explanations and tests.” Journal of Financial and Quantitative Analysis 25:2 (June 1990): 273–289. Online at:
  • Bris, Arturo, William N. Goetzmann, and Ning Zhu. “Efficiency and the bear: Short sales and markets around the world.” Journal of Finance 62:3 (June 2007): 1029–1079. Online at:
  • Diether, Karl B., Kuan-Hui Lee, and Ingrid M. Werner. “Short-sale strategies and return predictability.” Review of Financial Studies 22:2 (February 2009): 575–607. Online at:
  • Evans, Richard B., Christopher C. Geczy, David K. Musto, and Adam V. Reed. “Failure is an option: Impediments to short selling and options prices.” Review of Financial Studies 22:5 (May 2009): 1955–1980. Online at:
  • Figlewski, Stephen, and Gwendolyn P. Webb. “Options, short sales, and market completeness.” Journal of Finance 48:2 (June 1993): 761–777. Online at:
  • Geczy, Christopher C., David K. Musto, and Adam V. Reed. “Stocks are special too: An analysis of the equity lending market.” Journal of Financial Economics 66:2–3 (November–December 2002): 241–269. Online at:
  • McDonald, John G., and Donald C. Baron. “Risk and return on short positions in common stocks.” Journal of Finance 28:1 (March 1973): 97–107. Online at:
  • Seneca, Joseph J. “Short interest: Bearish or bullish.” Journal of Finance 22:1 (March 1967): 67–70. Online at:


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