Let’s end short selling in the crypto markets.
Shorting the stock market, of course, is perfectly legal: it’s the cause of the recent drama around GameStop. Big hedge funds thought GameStop was failing, so they bet on its demise. (In a short sale, you bet that a stock price will fall – unlike value investing, where you want the stock price to rise.)
When the Reddit r/wallstreetbets community saw this greedy (and possibly illegal) behavior by the hedge funds, they grouped together to buy GME: in essence, driving GameStop’s stock price in the other direction, and forcing the hedge funds to pay off their bets at a heavy loss.
All this crazy, speculative behavior was driven by short sellers, the robber barons of today’s stock market. Before I explain why we want to ban shorting from our emerging blockchain industry, let’s walk quickly through the history of why shorting is legal in the first place.
Shorting Seems Unethical; Why is it Legal?
Short selling (or “shorting”) has always been controversial: it was one of the issues that Congress considered before enacting the Securities and Exchange Act of 1934 (which, unbelievably, is still the primary law governing today’s hyperspeed, ultra-efficient markets).
The public continued to be suspicious of short selling, so Congress ordered the SEC to investigate the practice again in 1963, and again in 1976, and again after the financial crisis of 2008. Each time, the stock exchanges and market makers complained, so the SEC just tightened up some rules and called it a day.
History has shown the SEC is not going to ban short selling. (They may be powerful, but not that powerful.) Here are the arguments for and against.
The case to allow shorting: it puts downward price pressure on a stock that might be overinflated, serving as a kind of “friction” that keeps bubbles in check. (But that argument is hard to justify in recent years, where stocks like AAPL and TSLA seem divorced from any traditional financial valuation.)
The case to ban shorting: it hurts real companies, who must fend off short sellers who can spread rumor and gossip in an attempt to drive down the price. (Technically illegal, but c’mon, this is the age of meme stocks.) Short sellers, in other words, actively invest against a company, which is why many CEOs are crusading for short seller reform (read a fascinating story here).
Elon Musk, who has enough to worry about, has been fending off the short sellers for years. They keep betting that Tesla stock is overvalued: while they may be right, they’ve been wrong to bet against it, as the stock continues its meteoric rise. Musk is calling for short selling to be made illegal.
Sorry Elon, the SEC is not going to ban short selling. (You may be powerful, but not that powerful.)
Why is short selling still legal?
The market simply wants it. Because the market wants it, the market will get it. Instead of one way to make money (invest in great companies and wait for the price to rise), shorting gives you two ways to make money (bet on bad companies and gamble that the price will fall).
So don’t hold your breath that the stock market is going to change. But the “block market” – this new alternative stock market of bitcoin, cryptocurrencies, and digital assets – has a chance to do it right.
Crypto community, it’s up to us to regulate ourselves.
Let’s Cut Off Shorts
The idea is simple: let’s ban shorting of bitcoin, cryptocurrencies, or any digital asset.
This is self-policing that we need to do now, and the effects will be long-term and profound. Just as Congress got it wrong in the Securities Act of 1934 by allowing shorting, this time we can get it right. And our actions now, like that ancient and outdated law, will have repercussions for the next 100 years.
We can help the Reddit investors of the future – our children’s children – by building a better alternative to the stock market.
There are several ways to short bitcoin, and unfortunately one of the most popular – margin trading, where you bet with money that you don’t even have – is still available on some exchanges, including Kraken. (Reputable exchanges like Coinbase no longer offer margin trading, which is already a huge win.)
First, let’s step up public pressure on crypto exchanges that still offer margin trading: it’s risky and it puts smaller investors in financial peril. People get carried away with their emotions and bet money they don’t have. Margin trading (especially when combined with ignorance and/or alcohol) can really destroy a young investor’s financial future.
Second, let’s move crypto shorting to prediction markets. If you really think the price of bitcoin (or other digital assets) will go down, use prediction markets like Augur, where you’re essentially placing a bet the price will go down. While this may seem like the same thing as shorting, it’s not: you’re clearly making a “bet.” Prediction markets are clearly labeled as gambling, not gambling disguised as investing.
Third, let’s build up bitcoin futures markets, where you agree to buy bitcoin now at a theoretical price in the future. In an excellent Bloomberg article, former risk manager Aaron Brown explains why GameStop futures would have protected the stock market from the recent madness: the frenzy would have moved to futures markets, which are less volatile by design. The future of short selling bitcoin is bitcoin futures.
Here’s the plan in summary:
- Get rid of margin trading on crypto exchanges; move your money out of any exchanges that still offer it.
- Move crypto short selling into prediction markets, where it is clearly identified as gambling.
- Build the bitcoin futures market, which is less volatile by design.
Why do all this? Because banning shorting in crypto markets is in our best interest.
We can be a model to the SEC, to hold the block market to a higher standard of behavior than the stock market. It’s hard to complain that the block market is not protecting individual investors when we are doing a better job than they are.
The Securities Act of 1934 laid the template for how the stock market works for investors – and it’s proven very, very difficult to change. By self-regulating and self-policing our block market today, we can provide a better experience for generations of investors to come.
Let’s ensure our grandchildren don’t come up short.
John Hargrave is the author of Blockchain for Everyone: How I Learned the Secrets of the New Millionaire Class, known as “The Bible of Blockchain Investing.”