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Carson Block, founder of short-selling research firm Muddy Waters, speaks during an interview with Reuters in Washington, April 2, 2012. Mr. Block, 35, is perhaps the best known member of a group of short-selling investors and financial bloggers who allege fraudulent accounting practices among some China-based companies with U.S. or Canadian stock listings. (Benjamin Myers/Reuters/Benjamin Myers/Reuters)
Carson Block, founder of short-selling research firm Muddy Waters, speaks during an interview with Reuters in Washington, April 2, 2012. Mr. Block, 35, is perhaps the best known member of a group of short-selling investors and financial bloggers who allege fraudulent accounting practices among some China-based companies with U.S. or Canadian stock listings. (Benjamin Myers/Reuters/Benjamin Myers/Reuters)

Have you hugged a short seller today? Add to ...

A report from the New York Federal Reserve is making a splash on Thursday, given its conclusion: Bans on short-selling during tumultuous times not only fail to calm markets, they can actually make things worse.

“The 2008 ban on short sales failed to slow the decline in the price of financial stocks; in fact, prices fell markedly over the two weeks in which the ban was in effect and stabilized once it was lifted,” Robert Battalio, Hamid Mehran and Paul Schultz said in their report.

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“Similarly, following the downgrade of the U.S. sovereign credit rating in 2011 – another notable period of market stress – stocks subject to short-selling restrictions performed worse than stocks free of such restraints.”

Even when the ban on short-selling was implemented during those innocent days of 2008, many critics pointed out quite effectively that it was unlikely to have any positive impact. By targeting short-sellers, regulators were trying to identify an enemy of bull markets – but in fact were merely underlining how frightening investment conditions had become.

In the Fed paper, the authors go into some detail on the practice of short selling – which involves borrowing shares and then selling them in the hope of buying them back at a later date, at a lower price. While short-sellers are often vilified by companies, the bad reputation is misplaced: According to a 2004 study that looked at 327 disputes between companies and short-sellers, the average decline for companies targeted by short-sellers was an amazing 24.7 per cent in the following year.

Short-sellers claim that is because they correctly identified overpriced stocks. Companies claim it is because they spread false information. The authors of that study sided with the short-sellers: Many firms within the sample were subsequently revealed as being fraudulent. And the more companies complained about short-sellers, the worse their shares performed. Those that requested investigations into short-selling saw their shares fall 27.7 per cent over the next year.

All of which suggests that short-sellers are far from being enemies of normal market activity – and banning their activities is unlikely to turn bear markets into bull markets, or even provide much-needed stability when stocks are falling .

“Taken as a whole, our research challenges the notion that banning short sales during market downturns limits share price declines,” the authors said.

“If anything, the bans seem to have the unwanted effects of raising trading costs, lowering market liquidity, and preventing short-sellers from rooting out cases of fraud and earnings manipulation. Thus, while short-sellers may bear bad news about companies’ prospects, they do not appear to be driving price declines in markets.”

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