Short selling bans: The evidence
09 June 2020
State Street’s Travis Whitmore examines the effectiveness of short selling bans through an academic lens
Image: Sergey Nemirovsky/Shutterstock.com
Earlier this year, COVID-19’s impact on the world economy became apparent as countrywide lockdowns, many of which remain in place today, caused large-scale disruptions to global supply chains and significant unemployment. The resulting market sell-off and increased market volatility left governments, central banks and regulators with little choice but to intervene.
Regulators for their part imposed temporary short selling bans to try and curb asset price declines and reduce volatility. This is a common regulatory response during periods of market turmoil, with recent months being no exception. South Korea banned short selling in three markets, including its benchmark KOSPI Index, for six months. In Europe, Italy, Spain, France, Greece and Belgium temporarily halted short selling on hundreds of stocks.
Recently, as markets have calmed and countries begin to partially reopen, several regulatory bodies across Europe have lifted short selling bans. However, they remain in the toolkit for how regulators may respond if market conditions deteriorate. When referring to short selling restrictions, the European Securities and Markets Authority (ESMA) stated that, “it does not discard the possibility of extending the measure if the situation so requires”.
In this report, we review empirical findings from past academic studies to form an objective view on how short selling bans impact markets and if they are effective in stemming asset price declines and reducing volatility. Three key questions that we answer are: why are short-selling bans implemented? Are short selling bans effective in stemming price declines? Should regulators continue to impose short selling bans?
Why are bans on short selling common during market downturns?
The market downturn caused by COVID-19 is not the first time regulators have resorted to bans on short selling during periods of financial distress, as shown in Figure 1. Short selling has historically faced scrutiny, especially during market downturns. At the height of the 2008 financial crisis, the US Securities Exchange Commission (SEC) pointed to short selling as a driver behind the sharp decline in financial stock prices saying bans will, “protect the integrity and quality of the securities market and strengthen investor confidence”. When the market is under stress, regulators often say these measures are necessary to reduce market volatility and prevent further declines in asset prices.
The controversial nature of short selling restrictions, the availability of extensive data and the numerous event studies that demonstrate the impact that temporary bans cause have long garnered the interest of academics and resulted in a large body of work. These studies provide empirically based evidence and important insights that help us understand the effectiveness of short-selling bans in stabilising markets.
How do we study the impact of short selling and the restrictions?
Before diving into academic findings, it is helpful to understand the different types of studies that explore the role of short selling in capital markets. Empirical studies tend to fall into three main categories: (1) cross-country variation that leverage differences in regulations and market practices across countries, (2) event studies that analyse various historical events (e.g. short selling bans in 2008) and, (3) time-series and cross-sectional analyses that use daily or intra-day stock-loan data to examine the impact of shorting flow. Each research methodology provides a different perspective on the securities lending market and short selling.
What does empirical evidence suggest about the effectiveness of short selling bans?
There are several event studies that examine short selling bans during the 2008 financial crisis. One of the most extensive studies, Beber and Pagano (2013), analysed 30 countries during the financial crisis. The study, published in the Journal of Finance, found no statistical difference in excess returns of stocks for which short sales were banned and those stocks in which short selling was permitted, except for US stocks (due to the approval of TARP). In their own words, a short-selling ban was “at best neutral in its effects on stock prices”.
A paper published by the Federal Reserve Bank of New York found, “banning short selling does not appear to prevent stock prices from falling”, but instead “lowered market liquidity and increased trading costs”. Additional empirical evidence in a working paper from the European Systematic Risk Board agrees with the findings above while also suggesting that stocks targeted by short selling bans had increased volatility and the probability of default.
In addition, there are several studies that have shown short sellers to be informed market participants – increases in borrowing rates or shorting demand are correlated with abnormal negative returns. The evidence from these studies suggests short sellers are informed participants as they anticipate in fundamental declines in prices and are vital to achieving efficient prices, which we get into in more detail later.
While there is some empirical evidence that suggests bans are effective, the balance of evidence suggests bans have a limited impact on curbing price declines.
How do short-selling constraints impact capital markets?
In addition to the weight of empirical evidence suggesting that short selling bans have limited impact on stemming price declines, existing studies also suggest that these measures have unintended side effects on overall market quality. To help understand what these are, we review the role that short selling plays in capital markets through two primary market functions: liquidity and price discovery.
Liquidity is the ease with which an asset can be sold or bought and is commonly proxied for by the bid-ask spread. In illiquid markets, bid-ask spreads are wider resulting in costlier trades. Empirical findings from all three types of academic studies mentioned earlier tend to agree that short selling constraints reduce liquidity at the single-stock and broader market level.
A study of 111 countries found that in countries where short selling is more feasible, turnover – a proxy for liquidity – was 15 percent higher. Several studies of the 2008 financial crisis found that stocks subject to shorting bans resulted in spreads that were 200-300 percent wider when controlling for previous behaviour, as shown in Figure 2.
Lastly, time analysis suggests that short sellers can be liquidity suppliers when spreads are especially wide, providing a stabilising force in the stock market. Viewed holistically, these results suggest an unintended consequence of short selling restrictions are costlier trades that are more difficult to execute.
Price discovery is a critical process in financial markets in which the proper price of an asset is determined based on the incorporation of all available public information. Empirical evidence from the three categories suggests that short selling constraints restrict traders with negative information from expressing their sentiment, slowing the speed with which news is incorporated into market prices.
An analysis across equity markets in different countries reveals that in countries that permit short selling, stock-level prices incorporate information more quickly (as measured by the lack of synchronous movement in weekly returns). Price discovery was also slower for stocks impacted by the short selling bans during the 2008 financial crisis, especially where negative news was concerned. Lastly, when viewed through time, prices of stocks with short selling constraints (such as low lending supply) are less informative. Evidence also suggests increased “shorting flow reduces post-earnings-announcement drift for negative earnings surprises”.
During times of financial turmoil, regulators will commonly try to stabilise market prices by implementing short-selling bans and restrictions. We do not yet know how effective the recent short selling bans throughout Europe and Asia have been or their impact on market efficiency. However, the weight of historical academic findings suggests that these measures are not effective in preventing price declines, but instead result in a degradation of market quality at a time when it is most crucial. In an interview with Reuters at the end of 2008, Christopher Cox, then chairman of the SEC, said: “Knowing what we know now, I believe on balance the commission would not do it again.”
Regulators for their part imposed temporary short selling bans to try and curb asset price declines and reduce volatility. This is a common regulatory response during periods of market turmoil, with recent months being no exception. South Korea banned short selling in three markets, including its benchmark KOSPI Index, for six months. In Europe, Italy, Spain, France, Greece and Belgium temporarily halted short selling on hundreds of stocks.
Recently, as markets have calmed and countries begin to partially reopen, several regulatory bodies across Europe have lifted short selling bans. However, they remain in the toolkit for how regulators may respond if market conditions deteriorate. When referring to short selling restrictions, the European Securities and Markets Authority (ESMA) stated that, “it does not discard the possibility of extending the measure if the situation so requires”.
In this report, we review empirical findings from past academic studies to form an objective view on how short selling bans impact markets and if they are effective in stemming asset price declines and reducing volatility. Three key questions that we answer are: why are short-selling bans implemented? Are short selling bans effective in stemming price declines? Should regulators continue to impose short selling bans?
Why are bans on short selling common during market downturns?
The market downturn caused by COVID-19 is not the first time regulators have resorted to bans on short selling during periods of financial distress, as shown in Figure 1. Short selling has historically faced scrutiny, especially during market downturns. At the height of the 2008 financial crisis, the US Securities Exchange Commission (SEC) pointed to short selling as a driver behind the sharp decline in financial stock prices saying bans will, “protect the integrity and quality of the securities market and strengthen investor confidence”. When the market is under stress, regulators often say these measures are necessary to reduce market volatility and prevent further declines in asset prices.
The controversial nature of short selling restrictions, the availability of extensive data and the numerous event studies that demonstrate the impact that temporary bans cause have long garnered the interest of academics and resulted in a large body of work. These studies provide empirically based evidence and important insights that help us understand the effectiveness of short-selling bans in stabilising markets.
How do we study the impact of short selling and the restrictions?
Before diving into academic findings, it is helpful to understand the different types of studies that explore the role of short selling in capital markets. Empirical studies tend to fall into three main categories: (1) cross-country variation that leverage differences in regulations and market practices across countries, (2) event studies that analyse various historical events (e.g. short selling bans in 2008) and, (3) time-series and cross-sectional analyses that use daily or intra-day stock-loan data to examine the impact of shorting flow. Each research methodology provides a different perspective on the securities lending market and short selling.
What does empirical evidence suggest about the effectiveness of short selling bans?
There are several event studies that examine short selling bans during the 2008 financial crisis. One of the most extensive studies, Beber and Pagano (2013), analysed 30 countries during the financial crisis. The study, published in the Journal of Finance, found no statistical difference in excess returns of stocks for which short sales were banned and those stocks in which short selling was permitted, except for US stocks (due to the approval of TARP). In their own words, a short-selling ban was “at best neutral in its effects on stock prices”.
A paper published by the Federal Reserve Bank of New York found, “banning short selling does not appear to prevent stock prices from falling”, but instead “lowered market liquidity and increased trading costs”. Additional empirical evidence in a working paper from the European Systematic Risk Board agrees with the findings above while also suggesting that stocks targeted by short selling bans had increased volatility and the probability of default.
In addition, there are several studies that have shown short sellers to be informed market participants – increases in borrowing rates or shorting demand are correlated with abnormal negative returns. The evidence from these studies suggests short sellers are informed participants as they anticipate in fundamental declines in prices and are vital to achieving efficient prices, which we get into in more detail later.
While there is some empirical evidence that suggests bans are effective, the balance of evidence suggests bans have a limited impact on curbing price declines.
How do short-selling constraints impact capital markets?
In addition to the weight of empirical evidence suggesting that short selling bans have limited impact on stemming price declines, existing studies also suggest that these measures have unintended side effects on overall market quality. To help understand what these are, we review the role that short selling plays in capital markets through two primary market functions: liquidity and price discovery.
Liquidity is the ease with which an asset can be sold or bought and is commonly proxied for by the bid-ask spread. In illiquid markets, bid-ask spreads are wider resulting in costlier trades. Empirical findings from all three types of academic studies mentioned earlier tend to agree that short selling constraints reduce liquidity at the single-stock and broader market level.
A study of 111 countries found that in countries where short selling is more feasible, turnover – a proxy for liquidity – was 15 percent higher. Several studies of the 2008 financial crisis found that stocks subject to shorting bans resulted in spreads that were 200-300 percent wider when controlling for previous behaviour, as shown in Figure 2.
Lastly, time analysis suggests that short sellers can be liquidity suppliers when spreads are especially wide, providing a stabilising force in the stock market. Viewed holistically, these results suggest an unintended consequence of short selling restrictions are costlier trades that are more difficult to execute.
Price discovery is a critical process in financial markets in which the proper price of an asset is determined based on the incorporation of all available public information. Empirical evidence from the three categories suggests that short selling constraints restrict traders with negative information from expressing their sentiment, slowing the speed with which news is incorporated into market prices.
An analysis across equity markets in different countries reveals that in countries that permit short selling, stock-level prices incorporate information more quickly (as measured by the lack of synchronous movement in weekly returns). Price discovery was also slower for stocks impacted by the short selling bans during the 2008 financial crisis, especially where negative news was concerned. Lastly, when viewed through time, prices of stocks with short selling constraints (such as low lending supply) are less informative. Evidence also suggests increased “shorting flow reduces post-earnings-announcement drift for negative earnings surprises”.
During times of financial turmoil, regulators will commonly try to stabilise market prices by implementing short-selling bans and restrictions. We do not yet know how effective the recent short selling bans throughout Europe and Asia have been or their impact on market efficiency. However, the weight of historical academic findings suggests that these measures are not effective in preventing price declines, but instead result in a degradation of market quality at a time when it is most crucial. In an interview with Reuters at the end of 2008, Christopher Cox, then chairman of the SEC, said: “Knowing what we know now, I believe on balance the commission would not do it again.”
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