Borrowing an asset and "selling it short" facilitates finding the appropriate price for the asset, allowing people to bet that the asset is overpriced (e.g. in a "bubble"). Can bitcoins be sold short? Where and how?
Update (from Serith's answer): how about put options, which are similar?
Not only will Bitcoins soon be able to be sold short through several exchanges, but once that service is available, Bitcoin banks that pay interest will be possible.
A Bitcoin bank could pay interest on Bitcoin deposits by converting the Bitcoins into the least inflationary national currency available, investing those funds in loans or businesses, and using the profits to buy back more Bitcoins later to pay back depositors.
However, this plan has one flaw -- what if the price of Bitcoins goes way up, beyond the interest you can collect. You would then take a loss when you purchased back Bitcoins to pay back your depositors.
Normally, you would offset this risk by holding Bitcoins. But that would defeat the entire point of investing them. So you need some way to make money and risk money as if you were holding Bitcoins without actually holding any bitcoins. How can you do that?
And the answer is, you offset the risk that Bitcoins will go up in value by selling shorts. Selling shorts is like holding Bitcoins without having to actually hold them, allowing you to make money if they go up and lose money if they go down just like someone holding Bitcoins would. If Bitcoins go down, you lose on the shorts but make it up by making extra profits when you buy back Bitcoins to pay depositors. If Bitcoins go up, you lose when you buy back Bitcoins, but make it up on the shorts.
With the right combination of shorts, currencies, and investments, this should make the risk associated with interest-bearing bank accounts denominated in Bitcoins no greater than the risk with other currencies. (And if you sell the shorts directly to investors, you can make a profit on them as well, taking the commissions.)
It is entirely possible that this is part of the reason the exchanges are considering selling shorts. Not only would they pocket the commissions, but they could safely convert a fraction of the many, many Bitcoins they're holding into interest-bearing accounts denominated in national currencies, pocketing the interest.
Looks like CampBX will have it coming as well, see their FAQ for more info.
[Bitcoinica has closed]
You can do short selling and margin trading on https://www.bitcoinica.com. The initial deposit is very low. In fact, I was able to start trading immediately by depositing $5 in the form of MtGox USD redeemable code. You are then given some kind of loan so that you'll get a Tradeable Balance that is 5 times the amount of your deposit. You should keep an eye on your Net Value and watch out for a margin call. See "What's your Margin Call Policy?" in their FAQ.
Bitcoinica is more like a forex brokerage than your usual bitcoin exchange. Besides accepting orders from the users, they also trade with the other exchanges, primarily Mt Gox.
EDIT: Bitcoinica now supports deposit and withrawal of bitcoins.
The short answer is "yes", (eg http://mpex.co/). The long answer is "not really, and for some really fundamental reasons". Here's the long answer.
The various schemes that have been implemented or discussed for selling short BTC face the problem of credit risk. The short seller of an asset faces the possibility of arbitrarily large losses (the long side can only lose his investment). Ditto for the seller of an option (put or call).
The financial system deals with this by requiring the short to post initial margin, and top it up with variation margin if he loses money. If he fails to do that, or if the market moves so quickly that he can't, the broker who lent him the stock assumes the risk and tries to close out the position (possibly at a loss to the broker). The mechanism is slightly different with futures and options on futures, but the point is the same: someone takes on the risk of the trader holding a position that can suffer arbitrarily large losses (short seller, short options position, etc) to make sure that the other side of the trade is made whole. If your long put position, for example, fails to provide the payoff profile when the market crashes because the guy who sold you the put went bankrupt.. well, the contract hasn't really fulfilled its function.
The mechanism for doing this is financial intermediaries--brokers, exchanges, clearing houses--and legal recourse. The intermediary has a claim on the short's assets beyond his margin and can sue him. The long has a claim on the intermediary's assets, and if the intermediary fails, well, the taxpayer steps in and makes him whole (e.g., Treasury's bailout of AIG's short CDS positions vis-a-vis the major wall st. investment banks). What gives these contracts liquidity is the belief that the payoff logic will be honored regardless of the credit risk of the counter-parties.
But legal recourse is antithetical to the whole bitcoin philosophy, so I would argue that those trying to re-create these inherently leveraged contracts of the financial system in bitcoin land are trying to square the circle. Now you might say, "we can re-create the same without law and intermediaries, the short's counter-party takes the risk", but that would miss the point. A call option that only pays the long intrinsic value up to the short's margin is no longer a call option but something else; a stock loan market that leaves the guy lending btc to the short-seller with a loss because btc rallied hard and the short walked away from the trade is no longer stock loan but a highly risky trade. Call it what you will, but these contract's cannot really serve the same function in bitcoin land that they serve in the regulated financial system. Perhaps that is a feature, not a bug ;)
[HelloBitcoin has closed]
The first exchange to offer buying on margin or shorting is: http://www.HelloBitcoin.com
The requirements for shorting is the same as with stocks, a $2K balance.
They do not yet have enough orders and the spreads between the bids and asks are wide yet.
I doubt such put options will ever become a very liquid and deep market, because if they were, someone could in theory sell puts to go destroy the market value via volatility manipulation or buy the necessary Proof-of-Work control, both with the intention to destroy the value and interest in Bitcoin, and then collect profits on the put options.
Otherwise, and if they did not add incredible instability in the form of risk (see my comments under David's Schwartz's answer), then they could be helpful in smoothing out the volatility of the value of Bitcoins. Because some longs would hedge their positions as they got nervous at nosebleed levels, and this provides liquidity if a crash occurs, because they take profits on the puts and repurchase coins at a lower price, possibly hedging those new purchases with new puts.
Coinut is now offering Bitcoin PUT options settled by Bitcoins. You can trade either binary or vanilla options. It is now the only functioning Bitcoin options exchange.
[MtGox is shut down]
MtGox has Options listed as Coming Soon, that might be a substitute for short.
BitShrub.com is a "Bitcoin Option Market" [BitShrub has closed down]
The Calls and Puts can be sold or bought with other traders. The Option model is similar to traditional options, but with pricing in Bitcoin relative to the underlying fiat currency the option is written on.
The PUT option mechanics is explained here https://secure.bitshrub.com/support/
You can also go short by selling a Call option, but the risk graph is very different when compared to buying a Put Option.
MPEX has the MPOE (options exchange) in which CALLs may be written or bought, and PUTs which may be sold or bought. There is a barrier to entry in the one-time exchange registration fee.
ICBit offers trading of futures contracts, but those are not CALL or PUT options.
CoinSetter might be the first U.S. exchange to offer options when it launches (expected Spring 2013).
