When many of the world's regulators stepped in to temporarily ban short selling in the crumbling financial sector last September, they were hailed as coming to the rescue of victimized small investors. But mounting evidence suggests that they may have done investors more harm than good.
In a paper entitled "The Undesirable Effects of Banning Short Sales," Abraham Lioui, professor of finance at the EDHEC Risk and Asset Management Research Centre in Nice, France, found that the short-selling bans issued in the United States, Canada and most other major industrialized markets actually served to accelerate statistical measures of market volatility and risk. The study, which endeavoured to statistically isolate the effects of the short-selling ban from those of the financial crisis itself, also found that the ban was responsible for more of the market's volatility increase last fall than the crisis that had spurred it.
What's more, Mr. Lioui found that while the short-selling bans did heighten volatility among the financial sector stocks that were directly affected by them, the negative impact on the broader market was even more pronounced.
| Prof. Lioui's data | ||||||||
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Abraham Lioui, professor of finance at the EDHEC Business School in Nice, France, examined activity in financial stocks and broader market indexes, measuring for the impact of the financial crisis alone as well as for the additional impact of the short-selling ban on financial sector stocks that began last September. Mr. Lioui measured market volatility increases under the financial crisis and under the short-selling ban relative to normal market conditions (the "Coefficient" figures in the table), as well as the degree of statistical significance of those increases (the "T-Stat" figures). The findings show that not only did the short-selling ban add more volatility to the markets than did the financial crisis alone, but their statistical significance was much more pronounced. In other words, they were more likely to have had a visible impact on the market's behaviour. |
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| Volatility Coefficients | T-Stat (Statistical Significance) | |||||||
| Index | Financial Crisis | Short-Selling Ban | Financial Crisis | Short-Selling Ban | ||||
| Nasdaq | 0.02 | 0.08 | 3.41 | 6.74 | ||||
| S&P 500 | 0.02 | 0.09 | 3.16 | 6.54 | ||||
| CAC 40 | 0.02 | 0.05 | 2.43 | 3.83 | ||||
| FTSE | 0.01 | 0.05 | 1.06 | 5.45 | ||||
| DAX | 0.02 | 0.04 | 2.86 | 3.38 | ||||
| IBEX 35 | 0.01 | 0.02 | 1.29 | 1.91 | ||||
| SOURCE: EDHEC | ||||||||
"The immediate conclusion ... is that the market reacted more strongly to the ban than did the stocks that were the objective of the ban."
His findings are just the latest in a growing catalogue of reports that have been critical of the short-selling ban, which was instituted in mid-September after the collapse of Lehman Brothers triggered a devastating selloff in financial stocks that pushed many household names to the brink of insolvency.
The Investment Industry Regulatory Organization of Canada issued a report in February that concluded that the short-selling ban - which in Canada covered only financial sector stocks that were interlisted on U.S. exchanges - had hurt liquidity and the efficiency of trading in the affected stocks, considerably widening their bid/ask spreads, but "did not appear to have had any appreciable effect" on price declines. Two studies out of London earlier this year - including one commissioned by the London Stock Exchange - reported similar findings.
The World Federation of Exchanges, an umbrella group of about 50 financial exchanges around the world, is also believed to be preparing a study on the topic, in response to concerns among its members that the bans had been destabilizing.
Other academic studies have found that the bans may have contributed to heightened volatility, although unlike the EDHEC study, they didn't attempt to untangle the effects of the bans from those of the overriding financial crisis.
The findings are quite the opposite of what regulators intended when they issued the bans, in response to allegations that rumour-mongering short sellers were ganging up on some stocks so severely that they were jeopardizing the stability of not only the broader market, but the entire financial system.
"The commission has concluded that there continues to exist the potential of sudden and excessive fluctuations of securities prices generally, and disruption in the functioning of the securities markets that could threaten fair and orderly markets," the U.S. Securities and Exchange Commission said in ordering the short-selling ban.
The SEC lifted its ban in early October, as did the Ontario Securities Commission, which oversees activities on the Toronto Stock Exchange. But in some jurisdictions, including Australia, Italy and Germany, the ban remains in place.
Mr. Lioui suggests the bans might have actually exacerbated investors' frayed nerves, rather than calming them.
"The reaction was perhaps indicative of the market's lack of confidence in the capacity of regulatory authorities to guarantee fair markets and thus protect investors from those with the capacity to manipulate," he wrote.
Cleve Reuckert, an analyst at stock market research firm Birinyi Associates Inc. in New York, who has studied the effects of short-selling regulations and market volatility, agreed with that assessment.
"The ban on short sales did more to create fear that regulators were confused than it did to calm fears of short selling," he said.
Mr. Lioui concluded that the ban constituted a drastic rule change for the markets - which in itself shook confidence and certainty in the normal functioning of the markets.
"Markets must be convinced of the fairness of exchanges," he wrote. "The impact of the announcement of such an abrupt rule change is greater than the direct impact it has on the markets."
