The long and short of it
31 March 2020
Due to the extreme market volatility inflicted by the coronavirus pandemic, various bans on short selling has come into effect across all parts of the world. The question is, is it helping?
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There’s been much debate as to whether the short selling bans that have swept across Europe and Asia have made a positive difference or not. We’ve seen Italy, France, Belgium, Spain and Greece impose bans of various length and scope, while the Philippines has closed its financial markets down completely. According to those regulators, these measures are a necessity due to the turmoil triggered by the COVID-19 pandemic that has spread all over the globe.
The last time we saw the markets take a plunge like this was the 2007/8 financial crisis where most regulators around the world reacted by imposing similar bans on short selling. Although, these were often targeted at different sets of stocks and featured varying degrees of stringency.
According to subsequent research by Journal of the American Finance Association, these market authorities found that the bans were in fact detrimental for liquidity, especially for stocks with small capitalisation and no listed options. They also slowed price discovery, especially in bear markets, and failed to support prices (except possibly for US financial stocks).
Short selling is practised in near-on every major market and is often used by index creators to distinguish between developed and developing markets. It is a normal part of the everyday operation of exchanges where investors and traders meet on a daily basis. Yet the markets appear to be placing blame on short sellers. Why? Particularly when there is evidence demonstrating that the markets keep dropping despite the bans.
Ihor Dusaniwsky, managing director at S3 Partners explains that it’s no surprise. “A short selling ban, although possibly psychologically advantageous, would have pretty much no effect on the market volatility or pricing but may have an impact on liquidity”.
Meanwhile, Lynden Howie, European head of equity finance at Cantor Fitzgerald suggests that “given the scale of the sell off in equity markets recently, it’s hard to discern the impact of the short sale ban.” He notes that Spain and Italy first banned short selling over a week ago and their main indices have gained slightly.
France, in contrast, banned short selling a day after its southern neighbours and its main index was down 5 percent a week later, Howie further adds that the FTSE 100 is only down 1 percent despite short selling being allowed.
While much of the media’s focus is understandably on the markets that do act to ban shorting, it’s arguably more notable to look at the regulators that refrain from imposing a ban; especially those that did so during the financial crisis.
“The UK, Germany and Switzerland (to name just a few) market authorities have all kept short selling active as they publicly have stated seeing their respective markets trading appropriately, despite the recent volatility,” notes director at S3 Partners, Matthew Unterman.
Regulators want liquidity, market efficiency, price discovery and fair markets. Their tools to meet these objectives include rule-setting, disclosure and constraints and they use these tools to monitor, control and punish. Increased disclosure, such as the European Securities and Markets Authority’s (ESMA) move to drop the reporting threshold to 0.1 percent of a company’s shares is one example of regulators deploying their toolkit in an arguably more effective manner to meet those objectives. Italy’s CONSOB has also passed new rules to improve market transparency around short selling during this period of turmoil.
Roy Zimmerhansl, practice lead at Pierpoint Financial, a UK consultancy firm, says: “Anecdotally, I can say that some potential short sellers I have spoken with always stayed below the 0.2 percent threshold to avoid any potential damage for future engagement with target companies. The lowering of the reporting level will therefore likely have some impact while also enhancing ESMA’s visibility into market trading.
“While I accept that disorderly markets do not provide benefits for anyone, my view is that short selling bans that extend beyond a day are disruptive, distort markets and may create unintended consequences.”
As markets take a dive, short sellers and long sellers both participate, with every sale making the next sale more likely. A short seller will bet it all on a spectacular market crash, and the difference is that short sellers need to repurchase the shorted stocks in order to book profits. Short selling stocks allows traders to profit from falling prices and hedge the market risk of a portfolio.
At S3, Unterman says his team has crunched the numbers for the US market and says that short selling activity of $50 billion “is insignificant when looking at overall trading volumes” of $8-10 trillion.
“Long selling and deleveraging have been the driver of downward stock price movements, not short selling,” he adds.
Once a market has had a significant fall, the risk versus reward prospects shift and the potential profit for new short sales is seriously diminished, Zimmerhansl explains. “The further a market falls the less likely that short sellers have any meaningful impact and in fact, the market becomes exposed to long sellers with no shorts to act as buyers of last resort,” he adds. “Despite all the evidence that short selling bans don’t have any lasting effect, and if you accept my proposition that a market that has fallen more than 20 percent is a lot less likely to attract new short sellers, then why do regulators apply them?”
In the end, theoretical economic arguments on short selling are just a distraction from the fact that the real reason markets are tanking is due to the very real problem of a pandemic ripping through communities, shutting down businesses and disrupting trade. No amount of panicky fiddling with the knobs and levers in market control rooms around the world can overcome this fact.
Despite such a formidable problem and loud calls for decisive action from skittish politicians and investors that are watching their portfolios shrivel to nothing, regulators should hold their nerve, concludes Zimmerhansl.
With the wealth of evidence from recent history at everyone’s fingertips which highlight how previous bans negatively impact market stability in the long run, regulators should stick to the facts and resist being bullied into knee-jerk reactions to appease the street.
As the Italian philosopher George Santayana famously said: “Those who do not learn from history are doomed to repeat it.”
The last time we saw the markets take a plunge like this was the 2007/8 financial crisis where most regulators around the world reacted by imposing similar bans on short selling. Although, these were often targeted at different sets of stocks and featured varying degrees of stringency.
According to subsequent research by Journal of the American Finance Association, these market authorities found that the bans were in fact detrimental for liquidity, especially for stocks with small capitalisation and no listed options. They also slowed price discovery, especially in bear markets, and failed to support prices (except possibly for US financial stocks).
Short selling is practised in near-on every major market and is often used by index creators to distinguish between developed and developing markets. It is a normal part of the everyday operation of exchanges where investors and traders meet on a daily basis. Yet the markets appear to be placing blame on short sellers. Why? Particularly when there is evidence demonstrating that the markets keep dropping despite the bans.
Ihor Dusaniwsky, managing director at S3 Partners explains that it’s no surprise. “A short selling ban, although possibly psychologically advantageous, would have pretty much no effect on the market volatility or pricing but may have an impact on liquidity”.
Meanwhile, Lynden Howie, European head of equity finance at Cantor Fitzgerald suggests that “given the scale of the sell off in equity markets recently, it’s hard to discern the impact of the short sale ban.” He notes that Spain and Italy first banned short selling over a week ago and their main indices have gained slightly.
France, in contrast, banned short selling a day after its southern neighbours and its main index was down 5 percent a week later, Howie further adds that the FTSE 100 is only down 1 percent despite short selling being allowed.
While much of the media’s focus is understandably on the markets that do act to ban shorting, it’s arguably more notable to look at the regulators that refrain from imposing a ban; especially those that did so during the financial crisis.
“The UK, Germany and Switzerland (to name just a few) market authorities have all kept short selling active as they publicly have stated seeing their respective markets trading appropriately, despite the recent volatility,” notes director at S3 Partners, Matthew Unterman.
Regulators want liquidity, market efficiency, price discovery and fair markets. Their tools to meet these objectives include rule-setting, disclosure and constraints and they use these tools to monitor, control and punish. Increased disclosure, such as the European Securities and Markets Authority’s (ESMA) move to drop the reporting threshold to 0.1 percent of a company’s shares is one example of regulators deploying their toolkit in an arguably more effective manner to meet those objectives. Italy’s CONSOB has also passed new rules to improve market transparency around short selling during this period of turmoil.
Roy Zimmerhansl, practice lead at Pierpoint Financial, a UK consultancy firm, says: “Anecdotally, I can say that some potential short sellers I have spoken with always stayed below the 0.2 percent threshold to avoid any potential damage for future engagement with target companies. The lowering of the reporting level will therefore likely have some impact while also enhancing ESMA’s visibility into market trading.
“While I accept that disorderly markets do not provide benefits for anyone, my view is that short selling bans that extend beyond a day are disruptive, distort markets and may create unintended consequences.”
As markets take a dive, short sellers and long sellers both participate, with every sale making the next sale more likely. A short seller will bet it all on a spectacular market crash, and the difference is that short sellers need to repurchase the shorted stocks in order to book profits. Short selling stocks allows traders to profit from falling prices and hedge the market risk of a portfolio.
At S3, Unterman says his team has crunched the numbers for the US market and says that short selling activity of $50 billion “is insignificant when looking at overall trading volumes” of $8-10 trillion.
“Long selling and deleveraging have been the driver of downward stock price movements, not short selling,” he adds.
Once a market has had a significant fall, the risk versus reward prospects shift and the potential profit for new short sales is seriously diminished, Zimmerhansl explains. “The further a market falls the less likely that short sellers have any meaningful impact and in fact, the market becomes exposed to long sellers with no shorts to act as buyers of last resort,” he adds. “Despite all the evidence that short selling bans don’t have any lasting effect, and if you accept my proposition that a market that has fallen more than 20 percent is a lot less likely to attract new short sellers, then why do regulators apply them?”
In the end, theoretical economic arguments on short selling are just a distraction from the fact that the real reason markets are tanking is due to the very real problem of a pandemic ripping through communities, shutting down businesses and disrupting trade. No amount of panicky fiddling with the knobs and levers in market control rooms around the world can overcome this fact.
Despite such a formidable problem and loud calls for decisive action from skittish politicians and investors that are watching their portfolios shrivel to nothing, regulators should hold their nerve, concludes Zimmerhansl.
With the wealth of evidence from recent history at everyone’s fingertips which highlight how previous bans negatively impact market stability in the long run, regulators should stick to the facts and resist being bullied into knee-jerk reactions to appease the street.
As the Italian philosopher George Santayana famously said: “Those who do not learn from history are doomed to repeat it.”
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