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A close look at short selling from an Islamic finance perspective

Why it is done, the arrangements for minimising counterparty risk, and my view of the religious and investment questions.

Summary

Posted 18 April 2021

I get ideas for my monthly column in the magazine "Islamic Finance News" from many sources.

In late January the GameStop Corp. story was all over the financial pages, so I decided to base my February column on that. It was published in the 3 February 2021 issue, (Volume 18 issue 05).

The editorial limit on my columns is 600 words. With experience, I normally manage to write to about that length first time. However in this case I initially prepared a much longer draft to say everything I wanted to, and then cut it down to 589 words before submitting it to the editor.

Below I have taken my full initial draft, and even expanded it slightly, as my website does not have the space constraints of the magazine.

The GameStop story from an Islamic finance perspective

I had never heard of GameStop Corp. (its precise name) until my second son who has a strong interest in computer gaming emailed the story to me. As the story has had such extensive media coverage, I will not repeat it here.

Instead, as surprisingly many people do not understand short selling of shares, I want to explain why it is done, the precise mechanics, and then go on to discuss the Islamic finance questions as well as my personal approach.

Consider the hypothetical XYZ Inc which is traded on the stock exchange with a quoted price of $19.99 – $20.01 per share.

That means the market-maker will buy shares from you at $19.99 each (the “bid” price) or sell shares to you at $20.01 each (the “offer” price). This willingness to buy or sell at the bid / offer prices quoted is not for unlimited quantities, but will apply up to a specified, reasonable, quantity of XYZ shares. The market-maker’s income mainly comes from the bid-offer spread.

Accordingly, the price of a share is always clear; here $20 (ignoring the bid-offer spread).

If many people want to buy shares, the price goes up as market-makers keep adjusting the spreads upwards to encourage other holders to sell shares into the market. If many people want to sell shares, the price will similarly go down.

What they share is “really worth”, known as the “value”, is a matter of opinion.

Financial theory says that the value of a share is equal to all of its future dividend distributions plus any liquidation distribution discounted to present value at appropriate interest rates. The future dividends are obviously unknowable, and the discount rate depends upon how you evaluate future money compared to money today.

If you believe that the value of an XYZ share is much higher than its $20 current price, the logical thing to do is to buy the share. If you already own the share, logically you keep it.

What happens if your estimation of the value of an XYZ share is, say $5? Obviously, if you already own it, you should sell it for $20 as quickly as you can!

Why short selling happens and how it is organised

What happens if you don’t own XYZ shares? Is there a way to make money from believing XYZ's value per share is much lower than the current price of $20?

There is. You can sell the share, even though you don’t own it! As this looks so peculiar, it is important to understand exactly how the process works, and how the risks are managed.

Very briefly, you need to find someone, here called “the owner” who owns XYZ shares, and intends to continue to own them for the foreseeable future, who is willing to lend you say 1,000 XYZ shares.

The owner has several concerns:

Concern Resolution
Why should he lend you the shares? You agree to pay rent of say $0.05 per share per week while the shares are borrowed.
Will you abscond and fail to return shares? You deliver $20,000 cash collateral either to the owner or to an escrow agent, in exchange for the loan of the 1,000 XYZ shares.
What happens to dividends XYZ pays while the shares are lent out? You undertake to pay cash to the owner equal to the amount of those dividends.
What happens if the share price increases to say $30? The owner will then certainly have a credit risk if your cash collateral is only $20,000. You undertake to deliver additional cash collateral, so if the share price rises to $30, your additional collateral obligation will be $10,000.

With the above arrangements in place, lending you the shares is a risk-free way for the owner to earn rent of say $0.05 per share per week.

You can now sell in the market the 1,000 shares you have borrowed. The proceeds of $20,000 will restore to you the cash you have just delivered to the escrow agent as collateral for the loan of shares.

If your assessment of value is accurate, XYZ shares will go down in price.

For example, if they fall to $5 each, you can buy 1,000 shares for $5,000, return them to the owner, recover your $20,000 collateral, and you will have made a profit of $15,000.

Conversely, if the share price rises, you will be in negative territory, and for every $10 that the price rises, you need to post an additional $10,000 cash collateral until you run out of cash and become bankrupt.

Short sellers are often criticised as “bad people.” In my view, this is inaccurate. They perform a valuable social function by helping to steer share prices downwards if the price significantly exceeds their estimate of the value of the share.

Is short selling religiously permissible?

Islamic finance scholars prohibit short selling due to some hadith prohibiting the sale of what you do not already own. As I explained on my page "My view on the religious permissibility of futures trading", I do not regard those hadith as relevant when there are legal mechanisms in place, as described, above to eliminate any risk from the sale defrauding any of the parties.

The other arguments against short selling, namely excessive uncertainty (“gharar” in Arabic) or gambling (“maysir” in Arabic) are stronger in my view.

However, the uncertainty is no greater than going long (buying and holding a share), and the transaction is clearly not gambling since there are real shares being bought and sold.

Ultimately of course each Muslim needs to decide for himself or herself what they consider to be the correct religious position since they are accountable to God for their own individual actions.

My personal view of short selling

Have I ever done it? The answer is no despite being an investor for over 45 years.

The reason is very simple. If you buy a share, you can own it forever unless the company collapses into liquidation. At most, you can lose 100% of the price you paid, here $20 per share.

Conversely, short positions are expensive to maintain (you have to pay rent for the shares and you have to replace the missing dividends using your own money) and your losses are potentially infinite depending upon how much the share price might rise instead of falling as you predicted.

I have never regarded those downside risks as acceptable for the limited upside.

For example, the most you can make by shorting XYZ is $20 per share, since the lowest the share price can go to is zero. Conversely, if its price rises to $100, you will have made a loss of $80 per share from your short position, plus all the associated rental and dividend replacement costs.

 

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