Short Sellers: Isaac Le Maire's 1609 Bet to Soros and the Short Squeeze

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Short selling flips the usual trade: borrow shares, sell them, then buy them back later at a lower price to return to the lender. Lenders are mostly custody banks, pension funds and asset managers, who earn fees and hold cash collateral of about 102 percent of the shares' value. Investors with margin accounts usually sign hypothecation agreements that let brokers lend their shares; while a share is on loan, the short seller owes any dividend and the voting right passes to the new buyer. Naked shorting, selling without first locating a borrow, is largely illegal in the U.S. under the SEC's Regulation SHO.

The first recorded short seller was Isaac Le Maire, a former Dutch East India Company director who used forward contracts in 1609 and spread rumors, prompting a temporary Dutch ban. Herbert Hoover blamed short sellers after 1929, the U.S. adopted the uptick rule in 1938, and the SEC banned shorting of nearly 800 financial stocks in 2008. In 1992 George Soros sold borrowed pounds until Britain left the Exchange Rate Mechanism on Black Wednesday, making about $1 billion. The episode explains short squeezes, short interest and days to cover, and why Warren Buffett and Seth Klarman defend short sellers.

• Synthetic shorts using put options or total return swaps reach the same bet without borrowing any shares.
• The Bank of England raised interest rates to 15 percent in a single day trying to defend the pound.
• Studies from the New York Fed and Duke University found short selling bans did not stop prices from falling and reduced liquidity.
• In 2001 Krispy Kreme short sellers paid an annualized borrowing fee of 55 percent.
• James Chanos uncovered Enron's accounting problems before the SEC and rating agencies, and in 2011 short sellers exposed frauds at Chinese companies listed in North America.