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1 November 2013 CFA Institute Journal Review

Shackling Short Sellers: The 2008 Shorting Ban (Digest Summary)

  1. Jonathan Wheeler Hubbard

In September 2008, the US SEC surprised market participants by temporarily banning short selling in a number of financial stocks. Evidence suggests that the ban led to degraded market quality, particularly in larger-cap stocks. Although stocks on the banned list did see a price increase, it is plausible that anticipated government bailout programs, rather than the ban, are the reason.

What’s Inside?

In the years leading up to the recent global financial crisis, regulatory bodies in the United States eased restrictions on short sellers, repealing the NYSE uptick rule and other price tests that restricted short-selling activity. But in September 2008, the US SEC issued an emergency order that banned short sales on almost 1,000 financial stocks in an attempt to avoid further price declines in an already battered financial sector. The authors analyze the impact on market quality of the 2008 shorting ban as measured by spreads, liquidity, and volatility.

How Is This Research Useful to Practitioners?

Short sellers contribute to overall market efficiency by betting against overvalued companies and engaging in hedging activities, thereby providing liquidity and contributing to overall market efficiency. An outright ban on short selling could have a negative impact on overall market efficiency and quality. For example, Ni and Pan (working paper 2011) suggest that during a shorting ban, share prices take longer to reflect negative information. The authors explore the US market’s response to the shorting ban, using intraday trading and binding quote data to determine market quality before, during, and after the 2008 shorting ban.

They find that this shorting ban lessened shorting activity by an average of 77% in large-cap stocks affected by the ban. Small-cap stocks were not heavily affected by the ban. The remaining short sellers—that is, market makers who were exempt from the ban—experienced degradation in market quality with respect to spreads and price impacts. These remaining short-selling participants also appeared to demand immediacy, likely because market makers require rapid execution because of their role in the market and their desire to quickly hedge outstanding positions. During this ban, such market participants as algorithmic traders could not act as informal market makers, which reduced overall price competition and allowed the formal market makers to earn greater rents from participants seeking liquidity.

How Did the Authors Conduct This Research?

The authors look at actual intraday trading data based on data from the NYSE, NASDAQ, and BATS from 1 August through 31 October 2008. Their final sample includes 727 NYSE and NASDAQ stocks that were subject to the shorting ban. A matched control sample of 727 stocks that were not subject to the ban is created according to listed exchange, option availability, market capitalization, and dollar trading volume. The authors compare and examine the samples by using panel regression analysis.

Abstractor’s Viewpoint

The impact of regulations on security prices and the behavior of the diverse population of market participants serve as an important history lesson to both investors and regulators. Although many regulations are well intended and sometimes successful in achieving their goals, they can also have consequences that are not easily observable during the initial implementation.

Evidence of such consequences can be found in this study: Wider spreads and increased volatility are observed in stocks on the shorting ban list. It is impossible to know what would have happened had the SEC not implemented such a measure, but it is evident that market quality was severely degraded as a result of the regulation. It is plausible, however, that this tradeoff, although it came at a high cost to market participants, is what was needed at the time. Continued analysis of such impacts of regulatory actions as the SEC’s emergency ban on short selling may help regulators better weigh their options during market events and provide guidance for future actions.

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