Short-selling bans: The wrong answer in turbulent times

Edward Monrad, Optiver

Recent market volatility may have sparked the usual calls for bans on short-selling, but any such move would be counter-productive, says Edward Monrad (pictured), Head of European Equity Market Structure, Optiver Europe…

While regulators’ intentions to reduce stock market declines and diminish volatility are admirable, short-selling bans have shown to do just the opposite. In practice, these bans increase the likelihood of asset price bubbles forming and of retail investors overpaying for assets. They even increase the likelihood of fraud going undetected: in the ongoing Wirecard fraud, as with Enron, short-sellers were the ones who first sounded the alarm over the mysterious ‘disappearance’ of assets. At the same time, short-selling bans inhibit market makers from performing their regulatory duties of providing liquidity. Many academic, central bank and industry studies reflect the fact that short-selling bans are ineffective in achieving regulators’ goals. The reality is that short sellers are not responsible for declines in asset prices or increases in volatility. These market moves are caused by underlying external factors, such as the systemic banking crisis in 2008 and Covid-19 in 2020.

As short-selling bans can give a false impression of constructive action in times of turbulence, some regulators continue to enact these as emergency measures. This not only harms markets and investors at a time when they can least afford it, but it also ignores the ample evidence showing how unsuccessful these short-selling bans are. 

At Optiver, we are firmly opposed to short-selling bans for several reasons: they interfere with efficient price formation, reduce market makers’ ability to provide liquidity and dampen volatility, and introduce technical and regulatory complexities. Most financial-markets industry players share this position, and it’s underpinned by significant bodies of academic and industry research. A study by the Securities and Exchange Commission (SEC), for example, went so far as to identify a number of positive effects of short selling. According to its findings, short selling contributes to efficient price discovery, mitigates market bubbles, provides a check on upward market manipulations, increases market liquidity, dampens volatility, and facilitates the hedging of related positions. Conversely, short-selling bans negate these benefits. They come at an overall cost to the financial industry, ultimately harming all types of investors – including those saving for pensions.

This cost to the market – and to investors as a whole – comes down to two interlinked factors: short-selling bans increase the probability of retail investors and pensions overpaying for assets, while at the same time inhibiting market makers’ legal responsibility to provide liquidity and dampen volatility. In short, it’s the worst of both worlds, while also being ineffective in achieving their stated aim of reducing asset price declines.

So how do short-selling bans hurt markets?

Imposing short-selling bans means there are fewer parties able to sell than those willing to buy. This interferes with efficient price formation and blows up rice bubbles. By artificially removing the chance for some market participants to sell, asset price formation becomes less accurate, preventing financial markets from reflecting the real economy. This heightened uncertainty leads to further volatility, which in turn drives wider spreads and reduced liquidity. A case in point is the Japanese stock market’s historic peak in 1989, when its market capitalisation was the highest in the world. This overvaluation was exacerbated as short selling was long banned in Japan. The emergence of a futures market allowed for some short selling, with hedgers and short sellers contributing towards bringing price levels back to more reasonable levels.

Healthy markets are highly liquid. Market makers provide this liquidity, and consistently play an important role in the healthy functioning of markets, particularly during periods of volatility. This liquidity dampens the volatility of a stock. If anything, market makers’ ability to be effective should be strengthened during periods of volatility, rather than hampered. Short-selling bans achieve the exact opposite, harming market makers’ ability to provide liquidity to the market, widening spreads and diminishing displayed volumes. This makes it more expensive for investors and increases market-wide volatility. Short selling is an important tool for market makers to facilitate the investment decisions of others. It helps them fulfil their legal obligation to provide liquidity by showing two-sided prices to all market participant at all times.

Short-selling bans are typically deployed in times of crisis. They add complexity to existing exchange mechanisms, coming at the exact moment when markets can least afford to incorporate complexity. Markets should be as simple as possible to guarantee market integrity and ensure they work in a fair and orderly way. Short-selling bans achieve the opposite. They’re generally adopted piecemeal, so investors are suddenly forced to work within diverging regulatory regimes. The lack of a uniform application of rules can seriously impact participants who are active in many markets, or active in products – such as benchmark indices – with constituents in many regulatory jurisdictions. Equally, non-uniform application to participants located in different countries opens up possibilities for regulatory arbitrage. This can drive liquidity away from the markets where short-sale bans are present or incentivise trading in alternate, less regulated OTC products to avoid the regulations.

The right answer to turbulent times

In essence, short-selling bans only give the impression of constructive action by authorities without actually achieving a positive outcome. Indeed, they frequently cause harm to the markets and end-investors. As such, authorities should focus on measures to address the underlying cause of the stressed markets. This not only helps to solve the true problem at hand, but also helps to calm turbulence. Measures shown to support the healthy functioning of markets include liquidity protection and coordinated circuit breakers. Addressing underlying economic issues driving market volatility can be tackled by targeted actions. This includes fiscal stimulus and banking sector support (2008,) or by supporting SME and healthcare companies (2020). In parallel, speculative short-selling attacks on companies – which are of concern to markets and policy-makers and are often cited as the reason for short-selling bans – should be scrutinized through existing market-manipulation surveillance tools. In the end, the availability of reliable information that drives investment decisions will bring buyers back at the right price. Finally, Optiver supports any steps by authorities that increase simplicity, transparency, and liquidity: this works best for markets and for all investors everywhere.    

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