Aurora Borealis
1 March 2016 CFA Institute Journal Review

The Real Effects of Short-Selling Constraints (Digest Summary)

  1. Jakub M. Szudejko, CFA

Short-selling constraints affect asset pricing and corporate decisions. Using the US equity market as an example, the authors explain how the change in SEC regulation that allows for more efficient short selling may have an adverse impact on equity prices.

What’s Inside?

The authors analyze the role of short selling in the US equity market by investigating the impact of lifting “uptick rule” restrictions. They explain how this test affects market returns, price efficiency, and liquidity as well as the volume of short-sale transactions.

How Is This Research Useful to Practitioners?

The traditional uptick rule is viewed as a constraint on short selling and a limit on arbitrage strategies. The SEC’s Regulation SHO relaxed restrictions on short sales. Implemented at the beginning of 2005, the initial phase relaxed restrictions for a pilot sample of one-third of the stocks in the Russell 3000 Index; two years later, all stocks were included.

The authors show that Regulation SHO led to more short-selling activity and lower prices for firms in the pilot group, especially for small firms. A buy-and-hold portfolio of the small firms in the pilot group underperformed a control group (i.e., the remaining two-thirds of the Russell 3000) by almost 900 bps over the two years after the announcement of the test.

Surprisingly, abnormal stock returns were initially visible about two weeks before the SEC announcement date. Over the two weeks prior to the announcement, the cumulative abnormal return was −1.52% for all of the firms in the pilot group and −2.35% for small firms. These results suggest that information was incorporated into prices after SEC approval (23 June 2004) but prior to the public announcement (28 July 2004).

The authors look at investment and equity issues of firms in the pilot group and note a decline in capital spending compared with the control group. The results are particularly visible for smaller firms and for firms that may be overvalued (e.g., firms that experienced high short-sale volume).

They conclude that the source of negative market reactions may be a result of increased downside risk because firms in the pilot group became more sensitive to bad news than firms in the control group. In addition, the authors note that the probability of coordinated short-selling attacks on stocks is higher.

The study may be useful for investors and scholars who investigate short-selling activity or seek arbitrage opportunities. Regulators may also be interested in the potentially suspicious trading before the official date of announcement.

How Did the Authors Conduct This Research?

The study is based on market returns, market capitalization, and other firm-level data for the Russell 3000 companies gathered from Compustat and CRSP. The authors build the Russell 3000 for the pilot group and control group after filtering the sample for entities that were dropped from the index between June 2004 and January 2005 and excluding firms in the regulated utility and financial industries.

They first confirm the validity of the random selection of the firms in the pilot group and control group and note no major, statistically significant differences between the two groups.

Subsequently, the authors attempt to confirm whether the uptick rule is a binding constraint on short selling by constructing a monthly time series of short interest, which they use as a proxy for short-selling activity. They compare short-sale volume before and after the announcement day of the pilot program for the regulation by using regression analysis. The statistical significance is confirmed with a t-test.

Finally, the authors compare the differences in equally weighted excess returns between the firms in the pilot group and those in the control group around the approval date and the public announcement date of the pilot program.

Abstractor’s Viewpoint

Lifting uptick restrictions seems to be a relatively small regulatory change. But the authors find that it significantly distorted market equilibrium and triggered abnormal negative returns. The authors confirm that weak stock performance has a real effect on investment decisions because it clearly limits new issue opportunities. Furthermore, it is likely to scare away bankers who may be unwilling to provide capital for new investments.

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