From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
I started my first blog in August 2008, after months of declining markets and media criticism over short selling. The blog was called ‘Stock Lending Today – an Industry Under Siege’. The next month Lehman defaulted and the first of the short-selling bans was rolled out. So here we are again, temporary short-selling bans having been imposed in at least nine markets. The far smaller scale of the bans is a big difference compared to the last time when more than 30 countries had bans in place at some point.
With roots going back as far as 1609[i], short selling is practised today in virtually every major market and indeed is often used by index creators such as MSCI to distinguish between developed and developing markets. Nowadays, it is a normal part of the everyday operation of most exchanges where investors, traders and speculators meet, and prices are set. Well, usually short selling is part of everyday practice.
Regulators have several different objectives in overseeing markets – they want liquidity, market efficiency, price discovery and fair markets. Their tools to meet these objectives include rule-setting, disclosure and constraints and they use these tools to monitor, control and punish. Increased disclosure, such as EMSA’s move last month to drop the short-selling reporting threshold to 0.10% of a company’s shares in issue is one example of regulators deploying that toolkit. Anecdotally I can say that some short sellers I have spoken with always stay below the 0.20% threshold to avoid any potential damage for future engagement with target companies. The lowering of the reporting level will therefore likely have some impact while also enhancing ESMA’s visibility into market activity.
While I accept that disorderly markets do not provide benefits for anyone, my view is that short-selling bans that extend beyond a day are disruptive, distort markets and may create unintended consequences.
It is a fact that liquidity is negatively impacted as removing short sellers from the trading universe leaves a smaller group of traders that can participate.
Academics all point to wider bid-offer price spreads during short-selling bans, hurting all investors.
Short-selling bans intentionally damage price discovery as prices no longer are influenced by potential short sales changing the selling/buying balance, being biased towards buyers.
Traders that have both long and short positions have their behaviours changed, including cutting long positions (causing more selling pressure) to reduce exposures that are no longer able to be hedged cost-effectively. This includes strategies that are not solely dependent on price falls, including merger arbitrage or convertible bond arbitrage which also affects companies’ ability to raise money in this way.
Regulators may determine on balance that reduced liquidity and impaired price discovery may have offsetting benefits for their other goals. However, it must be acknowledged that aside from the temporary damage caused to the prevailing market, intervention may have a lasting impact on future investor participation in a market subject to artificial regulatory interference. A former Malaysian regulator I know shared his view with me a few years ago saying that the market restrictions – including a short-selling ban imposed during the Asian currency crisis of the late 1990s – caused non-resident investors to stay away from the market for a decade. It is therefore quite concerning to me to see another ban implemented there recently.
In many markets, would-be short sellers are required to ‘locate’ available securities prior to placing a short-sell order. Given lender holdbacks, access constraints by lenders and their agents and that some percentage of each security is probably already on loan prior to any crisis period, the ‘locate’ requirement caps the amount of short selling that can be done to a ‘market-executable’ size.
With all these potential market distortions, the most important question to ask is ‘do short selling bans work?’ The answer is ‘it depends’. According to a recent FT article by Jamie Powell[ii], one of the most referenced academic insights (Beber, Fabbri, Pagano and Simonelli), suggests that they don’t:
“Our results indicate that the short-selling bans imposed during the crisis are associated with a statistically and economically significant liquidity disruption, that is, with an increase in bid-ask spreads and in the Amihud illiquidity indicator, controlling for other variables. In contrast, the obligation to disclose short sales is associated with a significant improvement in market liquidity[iii].”
There are many observances since the Global Financial Crisis of a temporary respite: one-, two- or three-day price rises after a ban that leads to some people jumping on them and declaring triumphantly ‘they work!’. However, eventually, market sentiment drives price movement. Research conducted by The Economic Times of India found that in 12 of 13 instances of short-selling bans imposed over the past 20 years, the markets had fallen after the ban[iv].
I have softened my stance from late 2008 and now accept that there may be a case for imposing short-selling bans for smaller markets. Accordingly, I give a pass to Greece, Belgium, Austria and other small markets that determined such a ban should be applied. However, let’s look at the bigger European markets based on stock market capitalisation. According to the most recent year-end data from the World Federation of Exchanges (2018), France was the world’s fifth-largest market, followed by UK (8th), Germany (9th), Spain (16th) and Italy (19th) – all top twenty markets. Spain implemented its short selling ban on 17 March with France and Italy following on 18 March. The chart below is rebased to 18 March and goes to the close of business on 3 April.
It may be hard to read but let me give you the headlines. The market that has performed best: Germany (+10.85%) followed by Italy (+7.6%), France (7.4%), UK (+6.05%) with Spain at the bottom (4.25%). Hardly conclusive evidence that the short-selling ban had any positive impact. Even more so when you consider that short sellers that wanted to short Europe had to shift their focus so that Germany and UK both had additional short-selling pressure as a result.
This market crash happened after a historic 11-year bull run and ended with concerns over the global economic impact of COVID-19 and an oil production dispute between Saudi Arabia and Russia. When we see an inexorable upward trend, the amount of hedging through short selling of index names rises and unsurprisingly the markets eventually tipped over with an equally historic and rapid drop. In every market crash, investors of all types sell – long investors as well as short sellers. As markets tumble, short sellers and long sellers both participate, with every sale making the next sale more likely. The difference is that short sellers need to repurchase the shorted stocks in order to book profits so act as a dampener on further price falls.
Once a market has had a significant fall, the risk/reward dynamics shift and the potential profit for new short sales is seriously diminished. So, the further a market falls, the less likely that new short sellers have any meaningful impact and in fact, the market becomes exposed to long sellers with fewer shorts to act as buyers of last resort. I have argued this point on LinkedIn and other places but let’s see the evidence. The following chart shows the number of units that were borrowed, where 1 unit = 1 share. By showing the data this way, it is not distorted by stock price depreciation. It clearly shows that the amount of short selling in European equities dropped dramatically after the collapse in share prices. Remember, existing short positions were permitted to continue, including the markets with bans, so the drop is not a result of forced covering. I will admit that I called a peak about three days early, but the reduction was swift and meaningful.
So despite academic analysis and a lack of clear market evidence that short-selling bans don’t have any lasting effect, and if you accept my proposition that a market that has fallen 25%+ is a lot less likely to attract new short sellers, why do regulators apply them?
I’d like to add to the list of regulators’ objectives earlier – they want confidence in their markets.
Importantly, they have many stakeholders impacted by their decisions, obviously including issuers, investors and traders, but also governments themselves, politicians, the media and the public. Regulators that do not take immediate action may be subject to uncomfortable scrutiny from any of those stakeholders and feel the need to be seen to be doing something. Instead, regulators that hold their nerve and avoid knee-jerk reactions such as short-selling bans should be congratulated, and investors, traders, media and the public should have confidence that those markets operate fairly.
Returning to the name of my original blog – some years after it launched and in light of the academic evidence and regulatory recognition that where properly conducted and appropriately overseen, short selling makes a positive contribution to liquidity and price discovery, I changed the title to ‘Securities Lending Today’ and dropped the ‘An Industry under Siege’. Today, given the regulatory leadership of most major markets, I don’t see the need to revive the ‘Siege’. Bravo!
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[i]Robert Sloan “Don’t Blame the Shorts” (McGraw-Hill, 2010) p4 [ii]https://ftalphaville.ft.com/2020/03/18/1584523654000/Against-the-short-selling-ban/ [iii]https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2710371