The Problem With Banning Short Sales

In September 2008, with the global financial system collapsing, regulators believed they had to act fast. The pressure was on for them to do something to prevent stock prices from plunging to frighteningly
low levels. So the Securities and Exchange Commission put a temporary ban on short sales, a trading maneuver that amounts to betting that a stock's price will fall. The hope was that the move would prevent prices from tumbling further.

Did it work?

Mendoza College finance professors Robert Battalio and Paul Schultz say no.

The pair studied the effects of the 2008 ban and concluded that not only did it fail to stop stock prices from falling, the ban lowered market liquidity and inflated trading costs. Market makers on the options
exchanges were uncertain about their continued ability to hedge their positions by shorting. As a result of that uncertainty, options investors paid an extra half-billion dollars to trade options over the course of the three-week ban.

It's no wonder that a ban of this nature would sap market liquidity. In 2005, short-selling accounted for one in four trades on the New York Stock Exchange and nearly one in three on Nasdaq.

But as common as they may be, short sales are not for novice traders. Short-selling is designed to generate a profit in the face of declining stock prices. A trader arranges to sell a stock—which the trader doesn't actually possess—at today's price, all the while hoping the stock's price will fall. If it does, the seller can then purchase the stock at the new lower price and deliver it to a buyer at the earlier-agreed-upon higher price. The trader profits from the difference. But if stock prices do the opposite and go up, the seller ends up having to buy shares at the new higher prices to fulfill the purchase order and loses, rather than makes, money.

Short-selling is politically unpopular because it essentially means putting money on the prediction that stocks will go down. That seems un-American to some. As a result, short-sellers have been blamed during times of sharp market declines. Critics accuse them of driving stock prices down by misleading investors into selling stocks back at less-than-market value in order to make a profit on the price difference. Another accusation—one that drove the SEC ban—is that short-sellers intentionally diminish investor confidence in financial firms to make a profit.

In practice, driving stock prices to artificially low levels to make a profit would be difficult, if not impossible, according to Battalio and Schultz. One reason is that spreading false rumors about firms to decrease investor confidence is illegal and companies could take legal action. Another reason is that if a stock price was driven to an artificially low level through short sales, the price would likely rise to its original level once short sellers tried to close their positions by repurchasing shares.

"Short-sellers aren't the bad guys here," says Schultz. "Overpriced stocks are not good, just as underpriced stocks are not good. If short-sellers can push the stock prices to where they should be, that's a positive thing."

Earlier this year, Battalio, Schultz and economist Hamid Mehran published a policy paper with the Federal Reserve Bank of New York that looked at not only the adverse effects of the 2008 ban but what might happen in a down market if short sales were not restricted. "Market Declines: What is Accomplished by Banning Short Selling?" examined the effects of short-selling during August 2011, when Standard and Poor's announced a downgrade of the United States' long-term rating of sovereign debt. The authors found that the stock market fell by nearly 7 percent in a single trading day after the announcement—not because short-sellers were driving down prices, but because investors were dumping stocks.

Because it was published by the New York Federal Reserve Bank, the paper caught the eye of policymakers in the United States and abroad, gaining far more exposure than a traditional academic paper would, says Schultz. But the perception that short-selling bans are necessary in a down market persists, say the Notre Dame researchers. This past July, such bans were put in place in Spain and Italy.

"Short-selling is a perennial topic," says Schultz. "As long as regulators keep putting into place counterproductive bans on short-selling, there are going to be papers to write.… Hopefully regulators are reading them."