Shorting private markets

This is one of those things I’ll file in the “why didn’t I think of it before?” category.

The basic idea is that if you think there is a startup bubble, and that private companies (as a class) are being overvalued by investors, there exists a rather simple way to short the market – basically start your own company and sell equity to these investors!

The basic problem with shorting a market such as those for shares of privately held startups is that the shares are owned by a small set of investors, none of whom are likely to lend you stock that you can sell and buy back later. More importantly, markets in privately held stock can be incredibly illiquid, and it may take a long time indeed before the stocks move to what you think is their “right” level.

So what do you do? I’ll simply let the always excellent Matt Levine to provide the answer here:

We have talked a few times in the past about the difficulty of shorting unicorns: Investors can buy shares in the big venture-backed private tech companies, but they can’t sell those shares short, which arguably leads to those shares being overvalued as enthusiasts join in but skeptics are excluded. As I once said, though, “the way to profit from a bubble is by selling into it, and that people sometimes focus too narrowly on short-selling into it”: If you think that unicorns as a category are overvalued, the way to profit from that is not so much by shorting Uber as it is by founding your own dumb startup, raising a lot of money from overenthusiastic venture capitalists, paying yourself a big salary, and walking away whistling when the bubble collapses.

Same here! If you are skeptical of the ICO trend, the right thing to do is not to short all the new tokens that are coming to market. It’s to build your own token, do an initial coin offering, and walk off with the proceeds. For the sake of your own conscience, you can just go ahead and say that that’s what you’re doing, right in the ICO white paper. No one seems to mind.

Seriously! Why didn’t I think of this?

Shorting and efficient markets

The trigger for this blogpost is a tweet by my favourite newsletter-writer Matt Levine. He wrote:

And followed up with:

I responded to him with a tweet but thought this is blogworthy so putting it here.

The essential difference between an iPhone and an Apple share is that in the short run, the supply of the former is constantly increasing while the supply of the latter is fixed (follow on offers, stock splits, etc., which increase the supply of shares, are rare events).

The difference occurs because the “default action” (which is “do nothing” – caused due to inertia) has different impacts on the two market structures. In a market with constantly increasing supply, if customers “do nothing”, there will soon be a supply-demand mismatch and the manufacturer will have to take corrective action.

When the supply of the commodity is fixed, on the other hand (like an Apple share), the default action (“do nothing”) has no impact on the prices. You need a stronger method to express your displeasure, and that method is the ability to short the stock.