In an efficient market, the prices of financial assets should reflect all available information–good and bad–that may affect the magnitude and the risk of future cash flows from these assets. For this, we need to allow for the unimpeded flow of such information and unfettered actions of all participants in the markets. This central tenet of efficient markets was overturned when the SEC banned short-sales of shares of 799 companies on Sept. 18.
Similar restrictions have been imposed by the Financial Services Authority (FSA) in the U.K., the Australian Securities and Investments Commission (ASIC) and many other regulators around the world. This action has since been extended to more companies by the SEC and is subject to review on Oct. 2, when the ban may well be extended.
Is this a panic reaction by the SEC to the public outcry demanding that regulators “do something and not just sit there” or does it have some real economic benefits in the face of financial panic?
We believe the answer is the former and strongly recommend that the ban on short-selling not be extended beyond the end of this week.
Until the current financial crisis, shortselling was generally permitted in most countries, albeit with restrictions–such as the need to borrow the stock prior to the sale (“no naked shorts”), selling on a higher price than the previous trade (“the uptick rule”) and short-selling to capture gains and postpone tax payments (“no shorting against the box”).
In the U.S., some market participants (e.g., market makers) were exempt from the restriction on “naked” shorting. In the spirit of improving market liquidity, the uptick rule was lifted last July based on a pilot study of 1,000 stocks, commissioned by the SEC. Although shortselling volume could be large on certain days due to the response of market makers to the increased demand of buyers, open interest has, on average, been approximately 1% to 2% of shares outstanding. Even for financial stocks, this proportion has recently been typically around 3% to 4%. Prima facie, it is hard to see how this activity by itself would drive stocks to the brink of bankruptcy.
Who is selling short? For the most part they are market makers (in the stocks and in equity derivatives like options and futures), hedgers of various sorts (such as buyers of convertible bonds), risk arbitrageurs (profiting from the relative mispricing of the stocks of acquirers and targets in acquisitions) and hedge funds that use long-short strategies (where they buy “undervalued” stocks and sell short “overvalued” stocks).
Of course, pessimistic speculators who deem a stock to be overvalued will take risk by selling it short, hoping to be rewarded with an appropriate return. By the same token, if their guess proves to be wrong, they will pay a heavy price since their losses would be potentially unlimited if the stock rallies, contrary to their expectation.
Optimistic speculators would take the other side, ensuring a nice symmetry in the actions of speculators.
The collective action of all these participants provides the following benefits: Information about the company is disseminated faster than in a market with restrictions on short-selling, volatility is reduced, risk premiums are diminished and, most importantly, liquidity is enhanced, permitting a new buyer or seller to find someone to take the other side.
In fact, speculators who are considered culprits in the recent decline of financial stock prices are actually providing benefits to investors. By supplying important liquidity to the market, they lower the transaction costs that investors pay to execute their trades. Ultimately, investors are willing to pay for this improvement in liquidity, raising the prices of liquid stocks in relation to their less liquid counterparts.
When market prices decline, many market participants, such as mutual fund managers, want to avoid booking a loss. Thus, they are reluctant to sell losing stocks even if they consider them to be overvalued. Their withdrawal from the market in such times causes their pessimistic views not to be reflected in the stock price.
This “irrational” behavior is remedied, to some degree, by the rational activity of short-sellers who step in and incorporate their negative views into the market by their sales. The pessimistic information is then reflected in market prices. If not for these short-sellers, potential buyers would not be able to consummate their purchases in the market as easily, since there would be no potential sellers.
Two immediate consequences of the short-selling ban, aimed at halting the decline in the prices of financial stocks, may have already contributed to a further decline in prices.
First, many brokerage firms are restricting options trading transactions of customers, resulting in unanticipated short positions upon exercise, such as buying puts or selling calls.
Second, an important group of market participants that has exited positions in financial stocks are the “stat-arb” hedge funds that use computerized short-term long-short trading strategies in significant volumes. These players, who have been supplying huge liquidity to the market in recent years, have essentially dropped financial stocks from their trading platforms.
This diminution in liquidity will affect all financial firms but especially smaller financial institutions, which, in turn, will cause investors to flee these stocks and further reduce their prices in the face of declining liquidity.
Even if the short-sales restrictions are rescinded, bringing back the uptick rule is another futile and costly exercise. Forcing sellers to sell only when prices tick up prevents the rapid dissemination of negative information. The futures or options contracts that are not subject to this rule will reflect that information. Existing owners of the stock, who are not bound by the uptick rule, will then sell the stock they own and substitute it with the derivative asset.
For example, by the close of trading on Oct. 19, 1987, the S&P futures declined 40% while the index itself declined only by 20.5%. The arbitrageurs could not align the markets by buying the futures contracts and selling short the stocks due to the uptick rule, while the owners of stocks could buy the futures and sell their cash holdings, which people attempted to do the next morning.
The other problem with the uptick rule is the sheer unenforceability of the rule. There are many trading strategies that allow market participants to get around the rule. To cite just one common strategy, which is akin to “shorting against the box”: During an up or flat market, traders can buy stocks in one account and sell short the same stocks in another account, effectively having a neutral position that enables them to sell the stocks they own without being bound by the uptick rule.
At a broader level, the wealth of available evidence suggests that restrictions on short-sales are largely ineffective in halting declines of stock. All they do is throw some sand in the gears and delay the inevitable incorporation of bad news into stock prices. Academic research suggests that stocks with greater short-sales constraints exhibit greater “momentum” return, i.e., they will eventually experience greater volatility.
Similarly, stocks were shown to be overpriced when there were shortselling constraints, especially during the Internet bubble. These stocks had significantly more negative returns when the constraints were eventually relaxed. It has been shown that in countries with fewer shortselling constraints, there is more efficient price discovery, less co-movement of stocks and lower volatility than in those where shortselling is more restricted. Most importantly, no study has shown that short-selling constraints reduce the likelihood of crashes.
We sincerely hope that the SEC rises above the irrationality that has a firm grip on many politicians and policy makers in the U.S. and that it acts in the interest of ensuring orderly, liquid markets. Shooting the messenger to prevent the delivery of bad news is never a good idea.
Originally posted on Forbes.com on Sept 30, 2008 and reproduced here with the author’s permission.