A contrarian take on short-selling bans

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We’re generally pro-short selling around here — partly because being able to express both positive and negative views makes markets more efficient, partly because shorters are often interesting oddballs, and partly because many of their opponents are insufferable tools.

Another strong prior is that temporary short selling bans are dumb. They whiff of panic and classic “we must do something, this is something, ergo let’s do this”.

Most of all, they are probably ineffective at best and most likely counter-productive, actually exacerbating the sell-off they’re supposed to modulate. For example, this NY Fed paper from 2012 suggested how stocks that didn’t have short-selling restrictions did better than those that did.

But Alphaville is also a sucker for a counter-intuitive take, which is why this fresh report from the US Treasury’s Office of Financial Research caught our eye:

Despite strong predictions based on theories of disagreement, limited empirical evidence has linked short selling restrictions to higher prices. We test this relationship using quasi-experimental methods based on Rule 201, a threshold-based policy that restricts aggressive short selling when intraday returns cross −10%. When comparing stocks on either side of the threshold in the same hour of trading, we find that the restriction leads to short-sale volumes that are 8% lower and daily returns that are 35 bps higher. These price effects do not reverse after the restriction is lifted.

To simplify, the OFR paper found that temporary bans on shorts increased the returns of the affected stocks, lowered volatility, narrowed spreads and increased the depth of the market. Which is not what you’d expect!

The problem with testing the effect of short-selling bans is that they’re a product of interesting times. That makes it hard to disentangle their consequences from everything else going on.

For example: did a failure to stem the tumble of US banking stocks in late 2008, and the stabilisation after the ban was lifted, imply that short-selling restrictions didn’t work as intended? Or was it just that there was a big fat financial crisis going on, and that the ban was lifted once markets had stabilised?

To tune out questions of cause and effect, the OFR paper examines the temporary, one-day short ban that kicks in when a stock has fallen by 10 per cent or more from the previous day — Rule 201 from the SEC’s Regulation SHO, or the “alternative uptick rule”. This was designed as a circuit-breaker to prevent “potentially manipulative or abusive short selling” and “facilitate the ability of long sellers to sell first upon such a decline”, as the SEC puts it.

There is a lot of circuit-breaker data to explore, which is less true of haphazard occasional blanket short-selling bans. And according to the OFR report, the method works well:

We find that Rule 201 restrictions increase daily returns for triggered stocks. When comparing stocks that reach an intraday low return of just above −10% (i.e., unrestricted stocks) to stocks that reach an intraday low return of just below −10% (i.e., restricted stocks) in the same hour of trading, we find that restricted stocks have subsequent daily returns that are approximately 35 bps higher. Because our control group consists of stocks that had experienced similarly negative returns, our estimate of 35 bps is incremental to any price rebound or trading response that would counterfactually happen in the absence of the policy (Bremer and Sweeney 1991). Given that non-marketable limit orders are unrestricted, short sellers wishing to provide liquidity can submit orders freely. Nonetheless, these price effects do not subsequently reverse in the days following the trigger event, which is consistent with the restricted short selling opportunities being transient in nature.

Of course, this is too narrow an example so we should be wary of over-extrapolation.

These are one-day automatic restrictions in single securities. You can’t definitively conclude that broader, longer lasting short-selling restrictions are similarly effective. There’s a big difference between a routine, temporary, pre-determined and formulaic measure to calm one stock and an extraordinary open-ended regulatory action to prohibit trading that more often than not has been born of hysteria.

Still, it’s a conversation point. And you probably wouldn’t have clicked on this post if the headline was: “Circuit breakers appear to work as intended”.