Short selling bans and efficient markets: everything you need to know

We briefly look at what short selling is, its impact on market efficiency and some key research around the topic.

In bullish markets short sellers are often derisively referred to as contrarians and in the most extreme ‘market manipulators’.

However, research from both government and non-government bodies suggests that not only can short selling play a vital role in the maintenance of efficient markets; but some even argue that without short selling, liquidity dries up and trading costs can surge.

What is short selling?

Defined in its most basic terms, short-selling ‘is a trading strategy that traders use to take advantage of markets that are falling in price. When you short-sell, you are selling a borrowed asset in the hope that its price will go down, and you can buy it back later for a profit.’

Why is everyone now talking about short selling?

In 2008, the Australian Securities and Investments Commission (ASIC) temporarily restricted short selling activity amidst extreme bouts of market volatility. The regulator did that, in its own words, ‘to maintain an orderly market and mitigate the risk of market abuse.’

Though those goals may have been achieved, they came at a price: with ASIC itself conceding in a 2012 Report that those restrictions, ‘had negative impacts on the efficient operation of the Australian market. These included higher bid–ask spreads, lower turnover and encumbered price discovery.’

ASIC also noted that these bans may have impacted some investment managers, those using short selling as a hedging tool and certain listed financial firms.

In recent weeks – as market volatility again hits unprecedented levels – market commentators and investors have begun to speculate that short selling may again be restricted.

On Monday for example, the ASX 200 benchmark recorded its largest intraday drop in history, falling 9.7% or 537 points. Wildly, on Tuesday it reported its largest intraday rise.

Like Australia, US markets fared poorly at the start of the week: the Dow Jones index fell close to 3,000 points and the S&P 500 and the NASDAQ recorded substantial losses of 11.98% and 12.32%, respectively.

Interestingly, this time around, some market participants have beat the regulator to ban short selling, with UniSuper – the $85 billion superfund – on Monday announcing that it would be both recalling all its borrowed stock as well as suspending all stock lending for short selling immediately.

UniSuper took a similar line as ASIC did back in 2008, saying:

‘We are now in a market gripped by panic and we believe that restricting the ability to short-sell is in the best interest of promoting a more orderly market.’

Efficiency and volatility research

Yet just as ASIC acknowledged the negative consequences of banning short sales, a number of researchers have raised similar issues in the past, noting that restricting short selling can have a variety of unintended, negative consequences.

In a 2003 paper titled Efficiency and the Bear: Short Sales and Markets around the World, it is noted that although short sales may exacerbate price declines on an individual security level, short selling restrictions were found to be mostly ineffectual at fending off price declines at a market level.

In a long, but worthwhile passage from that paper, researchers note:

‘Our data strongly support the view that short selling facilitates efficient price discovery.’

And though it is pointed out that ‘short selling may also facilitate severe price declines in individual securities […] defined in terms of negative skewness.’

The researchers ultimately conclude that:

‘We find little compelling evidence that short–sales constraints prevent or mitigate severe price declines at the market level.’

In a more recent article, titled Market Declines: What Is Accomplished by Banning Short-Selling? Robert Battalio, Hamid Mehran, and Paul Schultz examine the impact short sale restrictions had on US securities during the GFC.

Here, the researchers note that:

‘Empirical evidence from the United States suggests that the bans had little impact on stock prices. Even with the bans in place, prices continued to fall.’

Though a negligible impact on equity prices, the researchers did find that such bans ‘lowered market liquidity and increased trading costs. On the latter point, we estimate that the ban raised total trading costs in the U.S. equities options market by $500 million in the period between September 18 and October 8, 2008.’

Ultimately, short selling represents a valid trading strategy that can be used by investors and traders to hedge their positions as well as potentially profit from falling asset prices.

What are your thoughts: should short selling be banned again or is it a vital part of a free and functioning market?

Either way, you can use IG’s world-class trading platform to go long or short on over 16,000 markets, including equities, indices and currencies. To get started, click here to create a live IG Trading Account today.

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