Short-selling bans during the crisis
Summary: (Via Voxeu)
Did the bans on short selling achieve their stated purpose of restoring order to the stock market and limiting unwarranted drops in prices? This column presents new evidence from 30 countries arguing that the effect on stock prices was at best neutral, the impact on market liquidity was clearly detrimental – especially for small-cap and high-risk stocks, and that the ban slowed down price discovery.
Introduction (Via Voxeu)
On 19 September 2008 – just as the failure of Lehman Brothers had shaken investors’ confidence in banks’ solvency and sent stocks into freefall – the US Securities and Exchange Commission (SEC) prohibited “short sales” of financial companies’ stocks. The hope was that this would stem the tide of sales and help support bank stock prices.
The SEC’s move sparked worldwide herding by regulators. In the subsequent weeks and months, most stock exchange regulators around the globe issued bans or regulatory constraints on short selling. Some of the bans were “naked”, i.e. only ruled out sales where the seller does not borrow the stock in time to deliver it to the buyer within the standard settlement period (naked short sales). Other bans were “covered”, ruling out also sales where the seller manages to borrow the stock (covered short sales).
Lessons Learnt (Via Voxeu)
The evidence suggests that the knee-jerk reaction of most stock exchange regulators around the globe to the financial crisis – imposing bans or regulatory constraints on short-selling – was at best neutral in its effects on stock prices. The impact on market liquidity was clearly detrimental, especially for small-cap and high-risk stocks. Moreover, it slowed down price discovery.
Perhaps the main social payoff of this worldwide policy experiment has been that of generating a large amount of evidence about the effects of short-selling bans. The conclusion suggested by this evidence is best summarised by the words of the former SEC Chairman Christopher Cox on 31 December 2008: “Knowing what we know now, [we] would not do it again. The costs appear to outweigh the benefits”. We hope that this lesson will be remembered when security markets face the next crisis.