TOMORROW, new regulations on short selling come into force across the European Union. Although designed to stabilise prices, they will have harmful effects on market quality, while producing few of the benefits claimed by their supporters.
We’ve been here before. During the early stages of the financial crisis, politicians pulled every plug they could to stabilise the banking system. Several European countries panicked and imposed individual bans on the short selling of shares in selected financial institutions, and on credit default swaps for Eurozone bonds. The US Securities and Exchange Commission also banned short selling on the stocks of big financial institutions after Lehman Brothers collapsed in 2008. Aggressive short selling was thought to have pushed down Lehman’s share price prior to its bankruptcy.
Regulators perceived, without factual basis, that short selling was a threat to the value of banking assets and government bonds, just when the markets needed certainty. Typically they banned – for fixed periods of time – naked shorting of specific stocks.
But this is not a tried and tested method for stabilising share and bond prices. Far from it. A study by Alessandro Beber and Marco Padano, first released in 2009, indicated that in most countries in which short selling was prohibited between 2007 and 2009, the ban was detrimental for liquidity, especially for stocks with small capitalisation and no listed options. It slowed down price discovery, especially in bear markets, and failed to support prices. At best, according to Beber and Padono’s research, short-selling bans left stock prices unaffected. At worst, restrictions may have contributed to further declines. Thus, previous attempts at the policy delivered nothing they intended to.
This makes recent pressure from European regulators and politicians to return to the policy so confusing. This latest Europe-wide ban on naked short selling of stocks and credit default swaps bears all the hallmarks of previous failed attempts.
The European ban includes provisions that firms must disclose short positions to regulators if they held more than 0.2 per cent of the issuers’ capital, and must do so publicly if they hold 0.5 per cent or more. But Oliver Wyman published a study in 2011 on the effect of disclosure regimes. It indicated that liquidity and trading volumes were considerably suppressed in stocks with public disclosure regimes, compared to stocks without.
While some national regulators, like Spain and Italy in July, have frequently introduced these bans overnight, the Europe-wide ban has at least been given due process. But without evidence to support the aims of the ban, and with little support from buy-side or sell-side firms that see the lower liquidity and wider spreads as a hindrance to business, the question is who is this ban intended to protect?
Dr Christian Voigt is business solutions architect at Fidessa.