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What happens if a short-seller goes bankrupt?

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short selling stock market

I’ve been wondering what to do with this blog for a while. I haven’t had time to do the technical deep dives I used to do. But I’ve also been reluctant to pivot into different kinds of articles. I’ll write more about that in the future (the summary is that I’ve been writing fiction instead of code in my free time). For now, however, I’ve decided to publish a non-technical shallow dive on something I do not understand very well: stock markets and economics.

This article came to me after reading Jack Rickard’s article The Tesla Conspiracy… or Am I a Dead Whistleblower?. I don’t know Jack or anything about him, but a friend of mine insisted it was a “must read article,” so I read it. I am a Tesla owner and I believe both in the mission and the future of the company, but I’m not interested in getting in the rabid Tesla debate. This article is about the stock market in general and the confusing topic of short selling in particular.

I’m not an economist, and I don’t even know if this interpretation accurately reflects how short selling happens on the market. I just started explaining the principles to myself and this story was the result. I hope it might be helpful to people who are about as confused as me.

What is shorting a stock?

Let’s answer this question with a concrete analogy. To understand this, let us give some names and numbers to our participants: Alex currently owns a car. Bernie wants to borrow Alex’s car, and Chris is interested in buying a car. There are also a few other cars and owners in the neighbourhood.

Shorting a stock is kind of like borrowing a car and promising to pay the person who loaned it for you later, at whatever value the car has on that future date. In this case, Alex is loaning her car to Bernie, and Bernie is contractually obligated to purchase the car in the future at whatever price the car is worth on that future date.

Assuming Alex and Bernie are both sane, there is no way Alex would loan a depreciating asset like a car on those terms. Let’s say the car was worth $30,000 when Alex loaned it to Bernie. And two years later it’s worth $15,000. Bernie got to drive a $30,000 car for two years and only has to pay $15,000 for it. Alex lost $15,000. Bernie would be all over that deal.

But what if the car is one of these mythical self-driving robotaxis that is increasing in value? In other words, it’s an appreciating asset. What if, after two years, the car is worth $50,000? Alex might be willing to go without a $30,000 car for two years if she can get $50,000 in the future. Bernie’s probably not going to accept that deal. It would be much better to purchase a $30,000 car today. She could drive a $30,000 car and have a $50,000 car in the future without giving Alex any money on that future date.

That’s simple enough. Things get interesting if Alex believes the $30,000 car is going to be a self-driving robotaxi in two years, but Bernie thinks it will be a $15,000 junker. In this case, they’ll probably both take that deal.

So far, this seems risk-free to Bernie. She can borrow a $30,000 car for two years. If she’s right and it’s worth $15,000, she can buy it outright. But if she’s wrong and it’s worth $50,000, she can give it back to Alex and say, “Thanks for the loan, bye!” Or, she could also say, “I’m just going to keep borrowing this car for a while because it’s eventually going to come back down to $30,000.” The point is, at any time, Alex has the right to say, “Ok, deal’s over. You have to return that car now or you have to pay me whatever it’s worth today (it might $15,000 or $50,000 or any other value on that day).

Remember Chris? What if Bernie is a wheeler-dealer type and sold the car to Chris for $30,000 on the very day she borrowed it? In other words, Bernie gets $30,000 in the bank today from Chris. In two years, she believes she’ll be giving $15,000 to Alex to pay for the car she borrowed. That’s a pretty sweet deal. Especially since Alex might just say, “Eh, you can keep the car, for now, it’s not worth it for me to ask for it back.” Alex might be thinking the car’s still going to be worth $50,000 someday and she’ll ask for the money later.

But what if Bernie is wrong? What if the car she’s already sold for $30,000 is now worth $50,000 and Alex says, “Hey Bernie, I want my car back or you have to buy it.” Bernie doesn’t have the car anymore, so she has to give Alex the money. Or she could buy an exact replica of the car from somebody else and give that car back to Alex. However, the replica is worth $50,000 now, so Bernie’s still losing $20,000 either way.

What happens to the stock value when it is shorted?

Now let’s think about the value of the car itself. When Bernie agrees to sell a car she doesn’t own, it actually decreases the value of the car. Let’s say there are four cars for sale in the neighbourhood, and Chris has the option to buy any one of them at $30,000. When Bernie puts the for sale sign on the windshield of this fifth car, the price of all five cars drops to $29,000. The sellers reduce their prices because they all know they’re competing for the same number of purchasers. On the other hand, more people might be willing to purchase the car at $29,000, than $30,000, so the price won’t drop any further. This is what supply and demand is. The fact that two people are willing to exchange cash for a car at a given price determines its fair market value.

Similarly, when Alex insists that Bernie return or pay for the car, it increases the value of all the cars in the neighbourhood. This is true regardless of whether the car is worth $15,000 or $50,000. Bernie has already sold the car to Chris and has to buy one of the other cars to return to Alex, at whatever price the neighbour is currently asking. Now the remaining cars for sale are worth more because the same number of people want to buy cars, and they’ve realized there are fewer of them available.

Bernie might decide to give cash to Alex instead of purchasing a different car to return. What happens to the value of the car in this case? It’s possible nothing changes. Alex might pocket the $15,000 or $50,000. But eventually, that money’s going to burn a hole in Alex’s pocket, and she’s going to want to buy a car. She might be willing to pay a little more than anyone else in the neighbourhood because she has all this spare cash. So all the cars go up in value.

Now here’s the question: What happens to the value of the cars in the neighbourhood if Bernie files for bankruptcy?

When someone goes bankrupt, somebody else always gets cheated out of their due. If Bernie goes bankrupt, Alex is the one who gets cheated. She was supposed to get $50,000 or a $50,000 car back, but instead, she gets nothing. Alex doesn’t want to get in this situation. If she senses that Bernie might be getting desperate for cash, she’s going to demand that Bernie return it. This will increase Bernie’s chances of bankruptcy, so hopefully, she hasn’t sold too many borrowed cars.

If Bernie goes bankrupt and Alex doesn’t get her money back from Bernie, Alex can’t afford to buy a new car. That means that neither supply, nor demand, is changed, and the value of the cars in the neighbourhood remains the same.

I’m starting to confuse myself at this point, but I think this means that by going bankrupt, Bernie has not only cheated Alex out of the entire value of her car, but she’s also cheated the entire neighbourhood (including Chris) out of having more valuable cars.

What if the short seller is deliberately manipulative?

This is what’s so interesting about Jack Rickard’s thesis. He has suggested that people who don’t want any robotaxis in the neighbourhood at all are deliberately borrowing cars and selling them to “flood the market” and reduce the value of the cars.

If Bernie is a normal short seller, she just wanted to make money betting that a car is going to drop in value. But she will change her mind and buy a car to return to Alex as soon as she realizes that Robotaxis are going to be a thing and become appreciating assets. Yes, she’s going to lose money, but she’ll only lose $20,000> If she waited and watched the neighbourhood robotaxis go even higher in value, she might lose $30,000 or more instead.

But if Bernie’s goal is to permanently reduce the value of all the cars in the neighbourhood, she could borrow lots of cars and sell them, then file for bankruptcy. This cheats all the people like Alex, who have loaned out their cars, as well as partially cheating all the other car owners out of what should be the real value of their car. Jack is suggesting that the market manipulation is even worse than that. He thinks that anti-robotaxi people are essentially paying Bernie to go borrow a bunch of cars and then bankrupt herself on purpose to reduce their overall value.

If people in Alex’s position start to believe Jack’s theory, they’re going to begin asking the Bernies of the world to return the cars they have borrowed and sold. If that happens, all the cars in the neighbourhood will go up in value for a while, until Bernie goes bankrupt and can’t return any more vehicles that She has borrowed.

Summary

If it’s not clear, the cars in this story are stock market shares. Bernie is a short seller who believes the shares are overvalued. Chris is a long buyer who believes they will eventually go up in price. Alex is likely a large fund who owns a lot of shares (because she believes they will go up in price) and wants to make even more money by letting the short seller borrow some of these shares to sell to long buyers. In a normal situation, all these people just want to make a profit and are making decisions based on what they believe the market will do. In the situation Jack proposes, Bernie is maliciously (and illegally) trying to reduce the value of the market.

People seem to want to put disclaimers on their articles, so let me add mine: I am a programmer, not an economist or financial advisor. Any risks you take because you believe the things I (or Jack, or anyone else) says is entirely your own. My article is not about TSLA, but because it’s a response to Jack’s article, I should mention that I own TSLA shares. I also own a Tesla Model X.

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