Short-selling has a long history and so too do government bans on actively betting on asset prices falling. Indeed short-selling, and government interventions to prevent it, are just about as old as the very concept of joint-stock companies.
The Dutch East India Company, or Verenigde Oostindische Compagnie (VOC), was established in 1602 by an amalgamation of several existing firms. It was granted an initial 21 year monopoly on Dutch trade with Asia and some scholars think of it as the world’s first transnational corporation. Unlike today’s multinationals, the VOC also possessed its own navy and was permitted to not only engage in trade but also establish colonies, sign treaties with foreign governments, mint its own coins, and even wage war.
In early modern Europe, being a government-chartered quasi-military company did not make the VOC unique. What was different about the VOC was how its capital was structured. Initially, any Dutch citizen with enough disposable cash was able to purchase a stake in the firm and those shares could later be bought or sold in open air markets, the largest of which eventually became the Amsterdam Stock Exchange. The VOC was, in effect, the world’s first joint-stock company and pioneered many of the features which are familiar to equity investors today. Even if few modern firms nowadays possess their own navy.
It did not take long for the idea of shorting to arrive. Isaac le Maire, a wealthy merchant from modern day Belgium, with a long involvement in the Asian spice trade was one the co-founders of the VOC and served on its first board of directors. But in 1605 he fell out with his fellow directors in a dispute over remuneration. He was ousted from the board and signed what modern lawyers would call a non-compete agreement, agreeing to forsake future involvement in trade between Asia and Europe. Truly nothing is new when it comes to corporate governance.
Le Maire, though, was a hard man to keep down and a surprisingly bitter one at that. He devoted much of the rest of life to trying to thwart the VOC. Together with a syndicate of other disgruntled and wealthy former VOC backers, Le Maire adopted a two pronged approach; he publicly criticized the VOC, its board and its decision making, and he also began to short its stock.
The shorting was done through the use of futures contracts, which had long been used by farmers to protect themselves from swings in the price of agricultural commodities. Le Maire and his syndicate’s innovation was to apply the same logic to asset prices. In his first contract, struck with a diamond merchant, Le Maire agreed to sell VOC shares to his counterparty in a year’s time for 145 Guilders, hoping that the price would fall and put him in the money.
The directors of the VOC somehow got wind of what was happening and were, to say the least, not especially happy about it. They petitioned the Dutch government to ban what they termed “these vile practices” and even had the temerity to argue that a falling VOC share price should be avoided as “many widows and orphans” were dependent on them. In 1610 the Dutch government responded by banning the practices of Le Maire in a decision which many see as the first example of stock market regulation.
The fact that the ban had to be reissued in 1623 and several times again in later decades suggests it was not wholefully effective. And nor would it be the last such ban. As long as equity markets have existed, someone has found a way to short stocks, and as long as stocks have been shorted governments have frequently stepped in to prevent what they term destabilizing practices. Napoleon went as far as to call short-sellers ‘an enemy of the state’ and threaten them with imprisonment in an episode that strangely enough somehow did not quite make the cut for Ridley Scott’s biopic movie.
Two hundred years after Napoleon, governments and regulators have often resorted to shorting bans at times of market stress. Such measures were common in both 2008 and 2020.
A recent paper published by the European Securities and Markets Authority, an EU government body, looked at the impact of short-selling bans in six European markets in six EU countries in 2020. It found no evidence that bans either helped or harmed the prices of banned shares over the period in question but it did find that the bans were associated with a deterioration in trading volumes and liquidity and increased market volatility. Interestingly the authors found that the decreased liquidity in the affected shares lasted well beyond the period in which shorting was banned.
Whilst boards of directors may still appeal to the authorities and governments may still frequently resort to bans on short-selling, economists are, in general, eminently relaxed about short-selling. A poll this week on the Finance Panel found strong support for the statements that allowing short selling leads to prices that are, on average, closer to fundamental values.
The economic evidence is clear – shorting bans usually cause more problems than they solve. No matter how often boards appeal in the name of widows and orphans.
For those interested in the early history of the VOC and financial markets, I highly recommend this website.
