• Milton Friedman Society

The Underestimated Perils of Short-Selling Bans

by Paolo Taveggia.

In the last few days, Belgium, France, Italy, Spain, and other European countries have decided to apply substantial measures to alleviate uncertainty and speculations in the markets shaken by the Coronavirus epidemic. National regulators have implemented temporary bans on short selling on a wide selection of listed stocks. In France, AMF banned short-selling in 92 stocks, in Italy, Consob halted such transactions for 20 stocks, while Spain further extended short-selling bans for the following month for all Spanish shares.

Short selling refers to the controversial trading strategy of borrowing shares and selling them in the open market, aiming to repurchase them later at lower prices, capitalizing the depreciation of the shares’ value. The practice is considered pretty risky since it can reward large profits but can accumulate tremendous losses.

Financial and academic experts seem to be divided on the effectiveness of such short-selling bans: some support them, some others are entirely against them. The majority of research papers and academic studies reveal that applying such limitations on market trading is not effective, and, in some cases, it could even increase the volatility and probability of default of the restricted stocks.

The former group tends to favor temporary restrictions imposed by national regulatory authorities in times of stress when predatory short sales can destabilize financial institutions. Brunnermeier and Oehmke's research (2008) reveals that short selling activity is beneficial only in “normal times” because it provides liquidity and precludes bubbles or overvaluations. On the other hand, in times of stress, predatory short selling can arise as financial institutions are subject to leverage constraints enforced by their uninsured depositors and short-term creditors that weaken their financial and liquidity positions. As a result, aggressive short selling can force the institution to liquidate long-term asset holdings at fire-sale prices, destabilizing the market.

The latter group supports that bans on short selling are not efficient. Many academic studies reveal that restrictions on market trading are not beneficial for market stability. For instance, Beber and Pagano (2013) found that short-selling bans during the Global Financial crisis in 2007-2009 were detrimental for liquidity, particularly for small capitalized stocks, slowed price discovery in bear markets, and had neutral effects on stock prices. The restrictions imposed in the past had at least a positive impact because they spread awareness and proved evidence that market constraints on short selling were more harmful than useful. As the SEC Chairman Christopher Cox said in an interview on 31st of December 2008, «Knowing what we know now, I believe on balance the commission would not do it again. The costs (of bans on short selling) appear to outweigh the benefits». Even though the Global Financial Crisis proved the restrictions inefficient, during the Sovereign Debt Crisis in Europe, several EU regulators applied bans on short selling, hoping to maintain financial stability and curb uncertainty. The stocks that had trading constraints faced more significant increases in the probability of default and more volatility than those not limited, especially for weaker financial institutions.

In short, from an ethical point of view, the attempt of financial regulators to calm the markets could be appreciated as a way to reassure confidence on investors and avoid the perception of possible speculations. However, the past has taught us several times that market restrictions do not provide benefits, but ultimately are harmful and detrimental for the natural efficiency and balancing effect of a free market. When we consider short-selling bans, we should not forget that the narrow benefits of the restrictions need to be weighed against the consequences of limiting the role of short-sellers in the market, which is to remove overvaluations and guarantee market quality and liquidity.

References

· https://www.bloombergquint.com/onweb/france-italy-spain-ban-short-selling-to-curb-market-plunge

· https://www.cnbc.com/2020/03/17/short-selling-bans-sweep-europe-in-hope-of-stemming-stock-market-bleeding.html

· https://www.ilsole24ore.com/art/cosa-sono-vendite-scoperto-e-perche-vietarle-non-sempre-funziona-ADaDABE

· https://www.ft.com/content/b1b758d4-682e-11ea-800d-da70cff6e4d3

· https://scholar.princeton.edu/sites/default/files/Predatory%20Short%20Selling_0.pdf https://ftalphaville.ft.com/2020/03/18/1584523654000/Against-the-short-selling-ban/

· https://www.esrb.europa.eu/pub/pdf/wp/esrb.wp64.en.pdf

· http://www.eief.it/files/2013/01/pagano_beber_joff_2013.pdf

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