Should short-selling be prohibited in order to stabilise the financial markets?

Introduction.

Short-selling is a method that enables one to make money from declining stock prices. When engaging in a short sale, the seller pays a charge to borrow the stocks from a guardian bank or a broker and then sells them to a buyer. When the price drops, the seller uses the money from the prior sell to purchase the appropriate stocks on the market, pays the borrowing fee, and makes a profit. When it has come to naked short sale, the trader takes advantage of the fact that the trade can be finalised up to several days after execution by selling the stocks without borrowing them or even checking to see if they are available. The trader has time within that period to find the stocks or purchase them on the market to settle the execution afterwards.1 during the financial crisis some countries banned the short-selling as they believed that short-sellers are manipulate the market and cause the volatility. The analysis below would help to conclude whether short-selling should be banned.

The Benefits of Short-selling.

The financial markets benefit in a number of ways from short-selling. Short positions offer distinctive information about the perceived value of the stock since short-sellers profit when stocks are overpriced. Short-sellers provide various advantages for investors and the financial markets as an additional information source. Short-sellers that take short positions provide all buyers access to more information, which should lower volatility. If information is shared with investors as soon as it becomes available, it should be valued in more gradually, preventing the big swings in stock prices brought on by the lack of symmetry of information. That is to say, when short-sellers alert the market that a specific company is overvalued, fast losses resulting from a lack of knowledge are less likely to happen. In turn, this ought to result in increased investor confidence generally.2

In a healthy financial economy, short-selling is a crucial activity. Because of its contribution to price discovery, reduced volatility, and increased liquidity, markets are more equitable and efficient. A short sale should be handled equally to a sale by current shareholders and as such, should be viewed as the symmetrical opposite of buying activity. It should go without saying that authorities should take prompt and proper action to stop any market manipulation that could be carried out by buyers, sellers, or even short-sellers. Officials also must thoroughly enforce the requirement that the investor or the borrower should not be a market maker before each short sale. The U.S. Securities and Exchange Commission, Financial Industry Regulatory Authority, and their equivalents in other states should mandate prompt reports on short-selling activities, similar to the current reporting requirements put in place for purchasers and sellers, in the sake of openness and uniformity.3

The empirical data unequivocally shows that short-selling is advantageous in "ordinary" or non-crisis situations. However, during times of significant drops in stock prices, heavy short-selling could have a disruptive impact on the securities markets. According to Geraci et al. 2018, short-selling has higher effects on smaller equities and accelerates downward return trends while raising volatility. In an extraordinary period of market hardship, this may lead regulators to apply short-selling restrictions in an effort to lessen the likelihood and severity of a stock market panic. Therefore, short-selling may be of concern to regulators at the start and during a crisis, even though the majority of empirical evidence points in the opposite direction.4

The disadvantages of short-selling.

The trading approach of short-selling is quite risky. This is because some experienced traders engage in a practise known as "naked short-selling," in which the trader short-sells stocks without first obtaining a loan against them or verifying that such a loan is feasible. Moreover, it is well known that certain traders will do anything to gain an advantage over their competitors. As a result, they may utilise false rumours to lead investors to accept a false narrative and so attempt to artificially influence a stock's price.5

Common objections of short-selling also included the fact that it encourages immoral behaviour and that short-sellers not only profit from other people's suffering but actively contribute to it. Short-selling gives value manipulators a weapon to drive down prices since, if nothing else, a further sale will drive down the price of a stock, hurting other investors in the company. Such "bear raids" decrease the effectiveness of the capital markets and make it more difficult for productive businesses to raise the necessary money, while short-selling raises market volatility. The volatility of stock prices may increase as a result of trading strategies used in short sales. Short-selling allows the separation of voting from ownership, while it may encourage "piling on" following negative news and increase price swings. Corporate robbers can purchase votes thanks to short-selling even when they have no real economic stake in the company. The raider would be capable of voting the shares in the long account, for instance, if they had an equivalent short position via a different account with a different broker and a long position through one of their brokerage accounts.6

Short-selling prohibitions.

Authorities in numerous countries implemented restrictions on short selling operations during the financial crisis of 2008–2009 and the Greek crisis of 2009–2010 in an effort to oust short sellers and stop further drops in stock prices. Academic research primarily reveals that short selling limitations degrade market efficiency, liquidity, and pricing, despite the fact that governments, authorities, and the mainstream blame short-sellers for escalating share market downturns.7

In an effort to lessen volatility and halt the downward trend in stock prices, securities authorities in Spain, Belgium, Italy, and France temporarily outlawed short-selling of financial companies on August 11, 2011. Short-selling restrictions are sporadic; as a result, the results of each ban warrant investigation. The examination of these prohibitions calls for extra consideration because it only considers markets in the European Union, in which there is little empirical data on the effects of short-selling restrictions. The restrictions have a negligible impact on the effectiveness of financial stock prices. Without bias, stocks that are subject to bans show a longer delay in assimilating unfavourable general information at the prohibition period. Therefore, if it was anticipated that the August 2011 restrictions would cause the market to react to unfavourable news differently, this objective was not accomplished.8

Supporting stock values is one of the claimed justifications for prohibiting short-selling. We employ an event study to evaluate this procedure's effectiveness. Stock prices will be unreasonably high during a short-selling restriction and will drop when it is lifted if Miller's price optimism model in 1977 is valid. According to Chang et al.'s empirical findings in 2012, which were focused on an event analysis of Hong Kong stocks, short-sale restrictions lead to lesser cost of capital, which raises prices. In either scenario, the lifting of the restriction on short sales of financial equities would result in negative anomalous returns for these securities.  Lim's (2011) model, however, contends that long-term short-sale restrictions would not affect prices since investors would take them into consideration.9

Outcome of the prohibitions.

The literature currently in existence ignores the potential impacts of short-selling prohibitions for herd behaviour, or the distribution of stock returns around market returns. Considering that institutional investors monopolize trading in established stock markets, restricting their ability to sell short could have a substantial effect on the asset pricing procedure. The purpose of this article is to close this gap and assess the effects of such regulatory actions. A natural experiment that allows for an evaluation of the herd behaviour within stocks impacted by short-sale restrictions in comparison to the set of unbanned stocks is dealing with restrictions on specific equities in six nations during the current financial crisis.10

While short-selling is prohibited, only investors who possess the asset are permitted to sell it. Because these investors are more knowledgeable than the average investor, there is a higher chance that a market maker will transact with one of these traders on the sell side of the market, which will result in more sell side information asymmetry. A restriction additionally discourages investors who do not own the asset from learning more, which lowers overall knowledge acquisition and worsens price efficiency. According to these forecasts, the 2008 short-selling prohibition in the United States had an asymmetrical impact on adverse selection that was almost entirely concentrated on the sell side of the market. This dominant factor increased transaction expenses during the prohibition, which caused the prohibition to disproportionately impact sell side liquidity.11

The single stock future (SSF) trade actions increase in London at the start of the ban period, along with a reduction of spreads, although volatility is not affected by the restriction. The rise in trade actions can be attributed to short-sellers' increasing demand as they switch to trading SSF. Additional analyses reveal that rather than hedging, the rise in trade is primarily speculative. As spreads narrow during the restricted period, the change in the volume of trading activity enhances market liquidity. The SSF market is capable of meeting the additional trading demand without lowering market quality because volatility does not rise despite the enhanced SSF trade. Propensity score analysis is utilized to get a randomised treatment variable, ensuring trustworthy inferences. Consistent estimates are observed when the difference-in-differences criteria is re-estimated with matched information, substantially supporting the findings.12

The data show that restrictions on short sales do not lead to increased bank soundness. In contrast, the estimates suggest the opposite outcome, namely that short sale restrictions tend to be connected with a larger probability of default, greater return volatility, and steeper stock price drops, specifically for banks. This is true even after controlling for the endogeneity of the bans. These negative impacts of short-selling restrictions may be interpreted as weakening the constraints that markets place on bank officials' risk-taking by silencing investors who are most critical of their business practises.13

Overall, these findings imply that the effect of the restriction on market efficiency is varied and, for the majority of the nations studied, minimal. Descriptive statistics study has also shown this diversity. In truth, this variability, including highly leveraged positions in the United States and Australia, may be explained, at least in part, by the clusters for financial company attributes by nation. We can draw the conclusion that some nations' restrictions were implemented for reasons other than the actual market circumstances of financial equities listed in those countries' jurisdictions. Furthermore, the limitations on short sales did not help to reduce the volatility of the financial equities affected by the restrictions; rather, the findings show that negative volatility was elevated for several nations.14

Covid and short-selling.

Concerns have been made concerning the ability of structured securities markets to carry out their fundamental duties of maintaining a fair, productive, and balanced market environment during periods of acute market hardship in light of the unusual shock of the Covid-19 outbreak. Therefore, it is crucial to consider whether regulators should step in during times of crisis in order to maintain the sustainability of the financial system. Throughout this global pandemic, short-sellers were more inclined to target specific types of businesses, such as those with significant Covid exposure risks, an international focus, or little financial or operational flexibility. This is consistent with recent COVID-19-related studies that show how the epidemic shock differs for various types of businesses. Further research indicates that during the COVID-19 epidemic, aberrant short-selling is less focused in undervalued stocks and is more focused in stocks that are overvalued. This outcome is not affected by sample restrictions, mispricing criteria, or the selection of regression models. Even though it appears that COVID-19-sensitive companies are more susceptible to pressure from short-sellers, it is important to note that value-driven short-selling still dominates in these companies. In context of COVID-19, prohibiting short sales may be a misstep because it not only reduces market liquidity but also drags out the integration of negative information, thus posing obstacles in the way of price determination.15

Conclusion.

Although we acknowledge that short-selling undoubtedly raises serious fairness concerns, that uncontrolled short-selling could debatably be somewhat devious, and that the related settlement missteps could potentially be damaging to the efficient operation of financial markets, what we actually discover is that there is no evidence to suggest that short-sellers intentionally caused price declines or otherwise negatively contributed to any market distortions. Instead, the softly regulated short-selling that was in place following Regulation SHO and continued through the middle of 2008 seems to have been net advantageous for pricing effectiveness and market liquidity.16 Legislators and economists encourage this sort of retractions. Short sellers artificially driving prices below their intrinsic values is a factor that frustrates them. However, it is difficult for short sellers to profit in this manner. Although short sales might lower stock prices, the short seller just makes money only when they purchase back their shares at a less value and close their position.17 When a short seller buys back shares, prices should return to their prior levels if purchases and sales have an equal and opposite effect on prices. With this tactic, the short-seller would not profit but instead incur trading losses. The short seller must successfully trick other investors towards selling while repurchasing shares at prices lower than those at which he originally sold them in order to profit. However, this is a risky plan that could turn out to be quite unsuccessful. The short-seller may incur significant losses if the clever investors push up share prices through their acquisitions if the short seller is successful in driving prices below basic values and they do so before he covers his shorts. Therefore, with all the discussed factors, it can be concluded that the short-selling should not be ban completely but let it happen with proper regulations and observations.

Reference.

1. Cinquegrana, P. (2009). Short Selling: A known unknown ECMI Commentary. ECMI Papers 1671, Centre for European Policy Studies.

2. Stanley, C. A. (2009). The panic effect: possible unintended consequences of the temporary bans on short selling enacted during the 2008 financial crisis. Entrepreneurial Business Law Journal, 4(1), 267-298

3. Brenner, M. and Subrahmanyam, M.G. (2009). Short Selling.

4. Bessler, W. and Vendrasco`, M. (2022). Short-selling restrictions and financial stability in Europe: Evidence from the Covid-19 crisis. Journal of International Financial Markets, Institutions and Money, 80.

5. Grimal, S. and Sammut, S. (2017). A Study on the Impact of the Short Selling Ban on FIBS. International Journal of Economics and Business Administration, V (1), pp.18–48.

6. Angel, J.J. and McCabe, D.M. (2009). The Business Ethics of Short Selling and Naked Short Selling. Journal of Business Ethics, 85, pp.239–249

7. Bohl, M.T., Reher, G. and Wilfling, B. (2016). Short selling constraints and stock returns volatility: Empirical evidence from the German stock market. Economic Modelling, 58, pp.159–166.

8. Alves, C., Victor, V. and da Silva, P.P. (2016). Analysis of market quality before and during short-selling bans. Research in International Business and Finance, 37, pp.252–268.

9. Helmesa, U., Henkerb, J. and Henkerb, T. (2017). Effect of the ban on short selling on market prices and volatility. Accounting and Finance, 57, pp.727–757.

10. Bohl, M.T., Klein, A.C. and Siklos, P.L. (2014). Short-selling bans and institutional investors’ herding behaviour: Evidence from the global financial crisis. International Review of Financial Analysis, 33, pp.262–269.

11 Dixon, Peter.N. (2021). Why Do Short Selling Bans Increase Adverse Selection and Decrease Price Efficiency? The Review of Asset Pricing Studies, 11, pp.122–168.

12. Benzennou, B., Gwilym, O. ap and Williams, G. (2015). Are single stock futures used as an alternative during a short-selling ban?

13. Beber, A., Fabbri, D., Pagano, M. and Simonelli, S. (2020). Short-Selling Bans and Bank Stability. The Review of Corporate Finance Studies, 10(1), pp.158–187.

14. Previati, D.A., Galloppoa, G. and Paimanova, V. (2021). Why do banks react differently to short-selling bans? Evidence from the Asia-Pacific area and the United States. The Quarterly Review of Economics and Finance, 80, pp.144–158.

15. Bessler, W. and Vendrasco`, M. (2022). Short-selling restrictions and financial stability in Europe: Evidence from the Covid-19 crisis. Journal of International Financial Markets, Institutions and Money, 80.

16. Fotak, V., Raman, V. and Yadav, P.K. (2009). Naked Short Selling: The Emperor’s New Clothes?

17. Battalio, R., Mehran, H. and Schultz, P. (2011). Reports Market Declines: Is Banning Short Selling the Solution? Federal Reserve Bank of New York Staff Reports, 518.