What is Short Selling in Financial Markets?

Introduction

In the financial market, whether it is traditional stock trading or crypto trading, short selling is a clear-defined and ubiquitous behavior. Basically, short selling and going long are counterparts in market operations. Opposite to long selling, short selling generally refers to the process of borrowing first and then selling, and then buying to repay later.

In short selling, there are usually market makers serving as an intermediate lending platform, similar to credit transactions. Using this trading mode, investors can often profit when prices continue to fall.

Let’s take stocks as an example. Investors borrow stocks from a brokerage firm when the stock price is high, and then sell them. When the stock price keeps falling, investors can buy stocks in the market and repay the brokerage, during which investors will earn the spread.

After reading this article, you will get to know some cases of short selling in the traditional financial market, as well as several typical short selling events in the crypto market.

In general, each ‘short selling’ that appears in the market reveals that some people are happy and others are worried. After all, behind every event is the violent redistribution of market funds. Now let’s get down to these sniper incidents created by experienced operators.µ

Short Selling Cases in Traditional Financial Markets

“Shorting is like digging out the heart and swallowing it before it stops beating.” Dick Fuld, CEO of Lehman Brothers, an investment bank, once used this analogy.

The traditional financial capital market has been running for hundreds of years, since then, short selling events have cropped up here and there in its long-term development. Especially when the stock market became big business, short selling incidents came one after another.

Perhaps, on the one hand, every successful short selling is a carnival for speculators; on the other hand, short selling is nothing else but venom for practitioners or holders of shorted assets in the financial market.

From the perspective of industry insiders, the short side is a “scavenging vulture” that is doing “cruel hunting”. It often appears inadvertently, and usually makes people shocked after it disappears.

The earliest short trader

（Source: jesselivermore.com）

Jesse Livermore successfully shorted U.S. stocks in 1929, which was a typical short selling event in the financial crisis of the 1920s. It has become one of the greatest trades in the history of financial trading.

His short selling has fully demonstrated the wisdom, patience, courage, and hardship required for financial transactions. Probably, only the case that Soros shorted the British pound in 1992 can rival this incident. During the whole transaction, Soros made a profit of $100 million in 9 days, becoming one of the ten richest people in the world at that time.

Even if Livermor was such an expert financial trader, who was called the grandfather of short speculators, that is the most brilliant record he could make. As early as 20 years ago in 1929, a short selling incident happened which was the earliest case in the history of modern financial development. Since it was the earliest one, the trader must have been the short selling pioneer - Livermore.

During the stock market crash caused by tight liquidity in 1906-1907, Livermore triumphed in the bear market. At that time, he noticed the news that the Northern Pacific and Northern Railway issued new shares, but shareholders could pay in installments.

It was the first time that such news came to Wall Street. Livermore judged that the market was tight on funds. A few days later, another large company, Sao Paulo, announced the issuance of new shares but stipulated that the payment period should be ahead of the above two companies. Livermore was convinced that there was a money shortage problem, so he decisively placed a large number of short orders.

Starting in late September 1907, money markets became tenser. In early October, when Livermore learned that money brokers were hoarding money and no one was willing to lend it out, he predicted that the stock market was about to crash. On October 24 of the same year, the U.S. money markets froze, and no central bank was willing to make loans. As a result, the stock market crashed - a crash that netted Livermore $1 million.

Afterward, Livermore successfully predicted a market crash in 1929, shorting the entire stock market.

Livermore became a living legend because of these cases. Since then, investors followed suit and imitated his short selling methods. Many of them have made greater achievements than Livermore.

Typical Short-Selling Cases

When it comes to whether a short selling case is typical or not, people usually focus on the twists and turns of a certain short selling event and judge whether its impact is great or not.

It is worth mentioning that short selling incidents by no means only affect the financial stock market in an adverse way. On the contrary, it is because a large number of individuals or institutions are engaged in short selling businesses that the issuance and trading of various stocks have gradually become more standardized.

After all, being favored by short sellers means that there are certain problems with a certain stock itself. Recent years have witnessed the fact that notorious short selling incidents indeed mostly occur in late-developing countries where the financial market is relatively new, or take place in emerging capitals listed on US stocks.

Among them, a series of sniping incidents initiated by Soros in the 1990s are famous cases of the former. Most readers have heard of them.

Muddy Waters Capital Short Sells China-Related Stocks

The case we cite here is one of the typical incidents operated by Muddy Waters that took place from 2010 to 2011. A series of short selling events by Muddy Waters Research Company successfully touched the nerves of users in China and the United States, two major economic countries. Meanwhile, the two countries fight fiercely in the short selling attacks launched by different emerging capitals. To some extent, the short selling incidents run by Muddy Waters Research are typical enough.

（Source: wikipedia.org）

The leading role of the incident - Muddy Waters Research Corporation of the United States, was established in early 2010 by Carson Bullock. At the beginning of its establishment, the company declared publicly that it would clean up those China-related stock companies and some American-related companies trying to fish in troubled waters.

So how could Muddy Waters obtain profit? It conducts research on the information of listed companies and cooperates with investors to short the stocks of listed companies, and then releases negative research reports to bring down the stock price. It initiates a class action lawsuit on behalf of small and medium-sized shareholders through lawyers to further cut the stock price. As a result, Muddy Waters, short traders, and the lawyers share the proceeds, while the listed companies suffer losses.

We can say that Muddy Waters Research has put its efforts into defeating the listed capital into financial reports, stock prices, etc., and systematically conducts short selling by virtue of public opinions and legal means.

On November 22, 2011, Focus Media, a China-related stock listed in the United States, released a third-quarter financial report, registering excellent performance and a net profit of $62.2 million. However, Muddy Waters Research issued a research report questioning its earnings, which resulted in a dip of 39.49% in its stock price.

Muddy Waters had doubts about Focus Media’s report and believed that it made a false statement about financial issues and insider trading issues. Moreover, Muddy Waters positioned Focus Media’s stock as a “strong sell”.

Faced with doubts from Muddy Waters, Focus Media made an official response in a timely manner and explained the doubts in detail, thereby winning the opportunity in time and gaining the support of Morgan Stanley, CLSA, and other institutions.

Although two American law firms subsequently announced that they would initiate an investigation into the company on behalf of all shareholders who bought shares of Focus Media between June 30, 2009, and November 20, 2011. However, Focus Media’s powerful counterattack upset Muddy Waters’ short-selling operation, which was a rare failure.

We can say that this short-selling operation was a rare failure because Muddy Waters Research Company is a professional short-selling institution who published a 30-page research report at the beginning of its establishment aiming at RINO Technology listed in the United States. In the report, it cites a series of evidence pointing to RINO’s fraud, bringing its falsified customer relationship, exaggerated income, and using funds raised by listing to buy luxury real estate to light. The stock price of RINO Technology dropped 15.07% on the next day. The company was suspended directly on the 8th day and was forced to be delisted from the market on the 23rd day.

After this incident, Muddy Waters Research was known to Chinese investors and became a famous short selling institution. In the subsequent short selling action against Focus Media, Muddy Waters Research Company adopted the same method, but it turned out to be a wild goose chase.

We can treat the two short selling cases launched by Muddy Waters Research as a series. Though it is not aboveboard, it has indeed sounded the alarm for many China-related stock companies listed in the United States that they should take a more honest approach when dealing with the market and investors.

Afterward, the Muddy Waters Research Company launched many other short selling actions. There are many similar short selling institutions in the market today. They serve as disguised supervision of the capital of all parties, and voluntarily help optimize the market.

Shorting Selling Cases in the Crypto Market

After getting to know about a few short selling events in the traditional financial market, let’s take a look at some short selling cases in the crypto market.

Before we get down to the business, you need to know that short selling in the crypto market is essentially no different from that in traditional financial markets. But they are not exactly the same. In the crypto market, applications supporting high-frequency trading and smart contracts are common. Besides, the entire market doesn’t have a standardized regulatory system similar to the traditional financial market. Therefore, crypto investors are more susceptible to the price changes of various cryptocurrencies and the influence of public opinion. Moreover, market makers, who have long existed in the market, seem to make short selling more frequent in the crypto market.

After over ten years of growth, the crypto market is inundated with a large amount of hot money, various investments, and fund institutions in the traditional financial market, which may bring about some surprising changes. Over these years, investors have also witnessed everything that happened in the crypto market from barbarism to an uncivilized state.

There are various mainstream coins and altcoins in the market. However, it is easy to understand that only those top-ranked coins can be shorted. After all, short selling of a coin without a huge amount of supporting funds will make no sense.

Short Selling in the Early Days

（Source: coindesk.com）

In the early crypto market, people had not yet developed a consensus on the blockchain. Short selling was mainly aimed at BTC. Besides, the market size was small. It was not big and valuable enough to underpin short selling.

Looking back, the first short selling event in the crypto market occurred between 2018 and 2020. The short parties targeted BTC whose price was rising all the way at that time.

The price of BTC had risen from $15,000 in three years to a new all-time high near $30,000 in 2020. The crypto market then was relatively big and the derivative trading market had been fully developed. There were some short selling events.

However, due to the anonymity of blockchain technology, the short selling traders remained unknown, and the whereabouts of funds were not as open and clear as the short-selling events in the traditional financial market. The sharp drop in BTC prices in February and November of 2018 were rare opportunities for short sellers. A few benefited handsomely in the process.

Many crypto users placed orders with 20x leverage, and even used ETH, EOS, BCH, and other currencies that were more volatile at the time. But thrill-seeking users had already tried various 100-fold leverages.

If we analyze this situation today, many users then needed to use spot stocks to open short positions. Big positions were easy to liquidate. Small positions seemed to make money, but the net value would keep shrinking. In this case, it was also necessary to consider the fluctuation of the exchange rate of the legal currency. After all, when different currencies are finally converted into different legal currencies, it would turn out to be a deficit instead. Therefore, even if it was an ongoing unilateral short market, users needed to continue to cover their positions, otherwise similar situations would occur. To put it simply, if users don’t clearly calculate their own positions and short sell blindly, it is easy to suffer losses.

The overall upward trend of various mainstream currencies in the entire crypto market has continued until the first half of 2022. When the overall market was undergoing an overheating process for a long time, most short parties did not really participate in short selling. On the contrary, after the entire market was in a cold state in 2022, short selling events targeting different currencies in the crypto market emerged one after another. Such is also the normal state of the market in a cold winter.

Typical Short Selling Cases

（Source: cybavo.com）

In the past two years, the value of the crypto market has reached trillions of dollars after the great development of the entire crypto ecosystem. The market now is like a behemoth. Immediately, it rose all the way but quickly turned into the bear market we are in today.

In the first and second quarters of 2022, various financial markets were affected to a certain extent by the Fed’s interest rate hike. As a result, investment panic shrouded the market. Certainly, the crypto market was no exception.

The overall downward trend hit the investor hard in confidence in the crypto market, and pessimistic remarks were gradually rampant. The prices of several mainstream currencies began to drop slightly. After that, the battle between the long and short market led to a UST price crash that can be called a black swan event.

LUNA Bankrupted and was Liquidated: caused by the UST death spira

The core of the incident revolves around LUNA and UST. Before the incident broke out, UST had been judged as a serious bubble by many investors due to a large number of additional issuances. Although the double-helix token model provided a guarantee for UST’s anchoring mechanism to the US dollar in the early stage, and the two tokens could be consumed and circulated in one direction, the continuous issuance of UST had increasingly weakened the market value of LUNA in the Terra ecosystem to a level that was not enough to supply all UST to maintain the role of USD stablecoin. Therefore, users in the ecosystem began to withdraw their funds and leave the market after a certain time node, which caused a run and was the beginning of the ensuing collapse as a whole.

UST needs to maintain its value on paper, that is, anchoring a fixed price of $1. The valuation of the Terra ecosystem has previously exceeded tens of billions of US dollars in the market, which is the false prosperity caused by the long-term additional issuance of UST. A large number of investors expect to obtain further profits by holding UST, which gradually reduces the proportion of UST used to burn and cast LUNA. As a result, the market shows a trend of lack of confidence in the price of UST.

To mitigate this decline, LFG introduced BTC for ecological reserves. However, LFG extracted $150 million of UST liquidity from the UST-3Crv pool to construct the subsequent 4Crv pool, which reduced the capital depth UST-3Crv pool to only about $700 million. That’s, funds prepared for dealing with short selling risks declined.

The short side who took advantage of this moment to profit also took this chance. The bug appeared in late March 2022, when LFG announced that it would start buying BTC and put it in the vault to help support UST. Then, LFG began to increase its holdings of BTC on March 22, and by March 26 it had a BTC position of over $1 billion. This foreshadowed the subsequent collapse of UST.

On April 1st, 4Crv announced the addition of UST. The short side began to take advantage of loopholes and started short selling. First, they borrowed 100,000 BTC and exchanged 25% of it for UST. There are still many speculations about the price at which the other 75,000 BTC were short sold, and it is only known that they were subsequently sold. LFG bought 150,000 BTC between March 27 and April 11, during which the average price of BTC was $42,000.

Immediately, the short side seized the opportunity of 4Crv to move the liquidity, and used a certain amount of UST in the UST-3Crv pool to consume the liquidity of the pool, causing a certain proportion of decoupling (the lowest point was 0.972). They created panic in the market. Then, LFG began to sell the BTC it held to defend the pegged exchange rate, which put a certain selling pressure on BTC. Subsequently, the short side’s action against UST officially began.

Curve ran out its liquidity. Bears used some of their remaining funds (around $650M) to start selling on Binance. Panic crept into everyone’s minds, which caused a real decoupling. As a result, investors withdrew from the market, and the run began to spread.

Both LFG and shorts were selling BTC, which eventually made the chain congested. After CEX suspended UST withdrawals, users panicked further as they wondered how much BTC they would have to sell to keep the peg.

Finally, the BTC price dropped 25% to $31,300 from $42,000 on April 11. In the end, the decline of BTC accelerated, UST broke its anchor completely, and the short side broke a leg.

In this typical short event, no one can accurately predict the ultimate profit of the short side because they are likely to short sell LUNA at the same time. However, if they closed their positions at an average price of $32K, they would have made at least $952M from this short, while the short side would not have lost over $20M in Curve’s UST dumping counterattack. The serious decoupling of UST on Binance cost over $100 million. Whereas, this doesn’t prevent the short side from finally obtaining a total profit of about $800 million.

Looking back at the whole process, we can find that BTC is the core of this incident. When LFG announced its entry into BTC, it was easy to foresee that they would continue to sell BTC in exchange for the peg of UST in order to prevent the price of LUNA from falling.

Before 4Crv was constructed, the liquidity of 3Crv was very low, which made the short side exhaust the liquidity with only $350 million. As a result, panic in BTC and UST arose in users’ minds.

This short selling incident directly impacted the entire crypto market. In order to hold the price of UST, LFG sold almost all of its assets to the market for cash. This caused the price of BTC to plummet, which in turn caused all other currencies in the market to fall. And it aroused panic among all investors.

Overall, the short selling campaign against LUNA and UST was premeditated malicious short selling. Of course, this has a lot to do with LFG’s own economic design. The double-helix token system seems to be stable, and the price anchor is also based on the mainstream currency of BTC. However, under the premise that the market has not yet been regulated and coupled with the unique crypto attributes of blockchain investors, the project with such a design can only adopt a passive defensive measure in the face of the short side who would finally take the advantage of the weakness in liquidity. This would lead to a chain reaction that eventually caused a crash that impacted the entire crypto market.

Many investors joined the short selling army and obtained profits in the incident. We cannot comment on their behavior because short selling is a reasonable investment method in the market. What is undeniable is that this incident has a significant impact on and is indeed a head-on blow to the entire crypto market.

Recent Short Selling Behaviors

（Source: resources.curve.fi）

The year 2022 has been turbulent for the entire crypto market. The upstream cryptocurrencies were affected by the UST incident, and the entire market value plummeted. As the vane of the entire market, BTC’s price has also fallen repeatedly. We can say that it faces the highest short selling risk. Under such circumstances, the outflow of capital and funds in the entire market is accelerating, and the overall downward trend of the market has led to more short selling events.

Audit Firm Misreads Alerts on Curve’s Contract Security

The recent short selling event against CRV caused the price of CRV to drop a lot in two or three days. The lowest nearly touched $0.4. However, the Curve platform pulled the market, and the price of CRV recovered.

Interestingly, the inflow and outflow of funds for shorting CRV came from the same crypto account. However, after reviewing the whole incident, it was found that as early as November last year, an audit firm named BlockSec claimed that Curve had a very large loophole, that is, funds locked up for more than a certain period would be stolen by hackers. In hindsight, the company misread the mechanism for withdrawing funds on the Curve platform. In fact, this is not stealing, but helping others to withdraw funds locked in the contract to obtain 1% of the income. It is a measure to promote ecological liquidity.

This information still caused uneasiness and panic among many Curve users. Even though the platform issued a statement in time and BlockSec deleted the relevant tweets, it still failed to boost users’ confidence. The price of CRV kept falling.

In this case, the short side found an opportunity to short. An account that staked tens of millions of dollars in USDC borrowed a huge amount of CRV, and continued to increase positions, aiming to short the price of CRV.

Faced with this situation, the founder of the Curve platform took measures to constantly sell other cryptocurrencies he held, kept increasing the margin for the platform, and promptly released the project white paper of the Curve platform, which boosted confidence in many swaying users.

After the price of CRV reached $0.4, the short side was actually unable to close the position. In addition, the project party continued to invite various influencers to offer support and published relevant information in different community channels. As a result, the short side failed.

On the whole, the short selling event of CRV didn’t seem to be much different from similar events in the past crypto market. The reason for its successful counterattack was to increase the margin for the platform as much as possible through manipulating capital. Meanwhile, it took advantage of public opinion to effectively maintain users’ interest and confidence in the project. In the end, it controlled the impact of short selling within a certain range under the crash pressure. Then, it ushered in a new round of rise in the currency price after the incident.

Conclusion

Short selling itself is just a trading mechanism without value orientation or emotions. The short side or the short selling institution plays a neutral role in the market. They can gain profits on the premise that the project discloses incomplete or even false information. Therefore, different short parties are also treated as scavengers of the capital market. They discover problems and bring the price back to a reasonable level through short selling.

It is very likely for short sellers to gain large profits in short selling. Whether it is for the traditional financial market or the crypto market, the risks of short selling are often long-term, extensive and comprehensive. To put it simply, investors or institutions seeking short selling opportunities are everywhere and watch every move in the market for a long time.

Nevertheless, it is undeniable that short selling is also a game. In order to gain more space for short selling, the short side will focus on leading public opinion. They mislead the market and bring panic to investors. The process costs a lot. Once short selling turns out to be a failure, the individuals or institutions involved will also have to bear the corresponding losses.

In a word, shorting is not a dirty or righteous behavior but a part of the mechanism in the capital market. The expansion nature of capital determines the occurrence of greed and malice. The short side is more similar to speculators behind the financial market and is inherent in the entire ecosystem.