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Short Selling Restrictions On Curbing Stock Price Volatility

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Question:

Financial Markets Regulators worldwide recently Imposed Short-Selling Restriction on Financial Securities.The primary purpose of this was to kerb Excess Stock Price volatility. Discuss if these Restrictions Successfully achieved their purpose.
 
 

Answer:

Introduction:

The financial economists consider short selling as an effective characteristic of the financial markets. According to the technical committee of the “International Organisation of Securities Commission (IOSCO)”, short sale helps in delivering highly effective discovery of price, declining bubbles in the market, raising liquidity of the market, facilitating hedging and reducing upward manipulations of the markets. The academic literature highly concurs with this perspective and it represents short sellers in positive light. These short sellers are considered as the refined accounting information users, since they assist in aligning the share prices with fundamental value (Chang, Luo and Ren 2014).  

However, majority of the market regulators have blamed short selling due to loss in market confidence. The “Financial Services Authority (FSA)” in UK, the “Ontario Securities Commission (OSC)” in Canada and the “Securities and Exchange Commission (SEC)” in US have flabbergasted the financial markets through implementation of a transitory ban on short selling of financial stocks on 18th September 2008. The other nations that had rapidly followed the suit by announcing identical changes in policy before the inauguration of the financial markets on 22nd September 2008 include Australia, Netherlands, Switzerland, Germany, France and Taiwan (Bebern and Pagano 2013). The basic intention behind such restriction on financial securities is to counter the ubiquitous tumult in the financial markets. In other words, it could be adjudged as a move to curb excess volatility of stock price (Beber, Fabbri and Pagano 2016). Thus, this assignment sheds light on ascertaining whether the restriction on short selling on financial securities have succeeded in achieving the above-stated purpose.

 

Achievement of short selling restrictions on curbing stock price volatility:

It has already been observed that the restrictions on short sale concentrate on the effect on share prices. According to the theoretical framework of Boehmer, Jones and Zhang (2013), the implication of short selling restrictions has been twofold. The first implication is that there is no availability of pessimists in the market and the optimists fail to consider the unavailability of pessimists at the time of price setting. The outcome is that with the enforcement of short selling restrictions, there is overvaluation of stock prices.

The empirical studies support the theoretical perspective that short selling restrictions result in an obstructed process pertaining to price discovery. In the research work of Bohl, Klein and Siklos (2014), the intention was to explore the impact of short selling restrictions on overvaluation by taking into account the association between short interest level and successive stock returns. It has been found that the stocks have encountered a decline in ownership breadth, which denote that the limitations on access of short seller to borrow stocks. In addition, the stocks tend to possess high valuations and the stocks have underperformed due to which the breadth increased.

Thus, the effectiveness of short selling banks on reducing stock decline concentrates on two major aspects, which are often considered as the merits of short selling restrictions. These two aspects include the performance of the stock market and its volatility. The following graph has been presented that represents the trend of the stock markets of Spain and Germany:

Figure 1: Index volume of the Spanish and German stock indexes in 2012

(Source: Crane et al. 2016)

The above graph denotes an indexed contrast of the Spanish stock index (IBEX) and the German stock index (DAX). The graph reveals that at certain times and under particular circumstances, the stock markets have risen and outperformed the stronger markets. On the contrary, many short selling restrictions have not witnessed any recovery and in most cases, they had no effect on downward moves (Fang, Huang and Karpoff 2015). In case of Spain, despite IBEX has outperformed DAZ following the instigation of the restriction, it does not consider the other influential dynamics. This is predominantly that the Spanish market has been underperforming severely in the global marketplace. Since the domestic problems were resolved with the help of actions like banking bailout, the Spanish market has been able to recover rapidly in contrast to many of its peers. Thus, by comparing the periods when the restrictions were in place and not in place, little correlation has been found between short selling and entire performance of the market. According to Helmes, Henker and Henker (2016), over greater timeframe and aggregated level, short selling levels have little correlation to the performance of the Spanish stock market; however, this does not indicate that the impact is nil. This is because during shorter timeframe and under particular circumstances, the activity of short selling could be a valuable indicator related to share performance. Thus, during this period, there is significant correlation.

 


In accordance with the research work of Jain et al. (2013), the restrictions on short selling influence the inclusion of both affirmative and pessimistic information into the share price in a different manner. They are of the view that short sellers are not likely to involve in short selling for reasons related to liquidity; instead of keeping informed. The short selling transactions minimise the speed at which the prices are adjusted with the private information. It has been found that the spot market of Paris Bourse, in which there has been existence of the restriction, has denoted positive news significantly in contrast to negative news.

 


The restrictions, when imposed on the Australian Stock Exchange (ASX), short sales are represented to the public right after execution. It has been found that short selling has higher influence on stock price compared to ordinary shares along with providing sufficient information to the short sellers. Even though the empirical work normally agrees on the notion that short selling restrictions affect the pricing efficiency, there has been mixed substantiation on whether short selling stabilises or destabilises the market. Thus, restrictions on short selling could be a direct reason or essential condition for unwarranted volatility and bubbles (Li et al. 2014).  However, the short selling restrictions have hindered arbitrage and they have contributed immensely to the 2000 stock market bubble. Thus, short selling constraints have helped in deterring some of the market participants from front running the investors that would restrict financial crises. Thus, in other words, short selling could destabilise the economy of the nation. In addition, it has been found that the share prices include negative information rapidly in nations, in which short selling is allowed. Thus, it supports the notion that the constraints associated with short selling are associated with smaller negative skewness in market returns. 

The global financial crisis of 2008 has initiated in US; however, it has spread rapidly to the other global financial markets. The equity market turbulence has resulted in implementation of short-term selling ban in many nations. Before the enforcement of this ban, naked short selling has been restricted for some ASX transactions, which are mentioned in “Section 1020B of the Corporations Act”. On 19th September 2009, the “Australian Security and Investments Commission (ASIC)” have responded to the issues, which the international market conditions are going through due to stock short selling of the stocks (Massa, Zhang and Zhang 2015). The financial securities that have been restricted from short selling in Australia comprise of the following:

  • Securities belonging to S&P?ASX200 including property funds
  • Five “Australian Prudential Regulation Authority (APRA)” regulated organisations that include Wesfarmers, The Rock Building Society, Wide Bay Australia, Futuris Corporation and Calliden Group.

After the imposition of the ban, it has been found that the turnover of average dollar for the Australian stocks has been $37.588 million in 2009, which is 0.77% of the overall market turnover on ASX. On the other hand, the turnover of average dollar has been $29.285 million, which is 0.55% of the overall TSX market for Canadian stocks. Thus, the Australian stocks have illustrated inferior performance in relation to their counterparts of Canada in terms of market quality, which are measured with the help of bid-ask spreads and intraday volatility (Mohamad, Jaafar and Goddard 2015). Thus, it could be inferred that the Australian stocks display bugger spreads and greater intraday volatility in contrast to the control Canadian stocks despite the constraints on short-term selling.

 

Conclusion:

From the above discussion, it has been found that short selling helps in delivering highly effective price discovery, declining market bubbles, enhancing market liquidity, facilitating hedging and reducing upward manipulations of the markets. These short sellers are considered as the refined accounting information users, since they assist in aligning the share prices with fundamental value. Finally, politics has been the major force behind the enforcement of restrictions on short selling. The bans might have a place and the restrictions are necessary to prevent the turmoil of the financial markets. However, it has been difficult to prove that without such restrictions, things might become worse. In addition, the potential related to short selling restrictions might cause additional problems, instead of solving, which need not be ignored. This is because the Australian stocks have not performed better in contrast to the Canadian stocks and similar is the case of Spanish stock market compared to the German stock market. Thus, there is minute evidence of supporting the idea of their usefulness.

 

References:

Beber, A. and Pagano, M., 2013. Short?selling bans around the world: Evidence from the 2007–09 crisis. The Journal of Finance, 68(1), pp.343-381.0.

Beber, A., Fabbri, D. and Pagano, M., 2016. Short-selling bans and bank stability.

Boehmer, E., Jones, C.M. and Zhang, X., 2013. Shackling short sellers: The 2008 shorting ban. Review of Financial Studies, p.hht017.

Bohl, M.T., Klein, A.C. and Siklos, P.L., 2014. Short-selling bans and institutional investors' herding behaviour: Evidence from the global financial crisis. International Review of Financial Analysis, 33, pp.262-269.

Chang, E.C., Luo, Y. and Ren, J., 2014. Short-selling, margin-trading, and price efficiency: Evidence from the Chinese market. Journal of Banking & Finance, 48, pp.411-424.

Crane, A.D., Crotty, K., Michenaud, S. and Naranjo, P.L., 2016. The causal effects of short-selling bans: Evidence from eligibility thresholds.

Fang, V.W., Huang, A.H. and Karpoff, J.M., 2015. Short selling and earnings management: A controlled experiment. The Journal of Finance.

Helmes, U., Henker, J. and Henker, T., 2016. Effect of the ban on short selling on market prices and volatility. Accounting & Finance.

Jain, A., Jain, P.K., McInish, T.H. and McKenzie, M., 2013. Worldwide reach of short selling regulations. Journal of Financial Economics, 109(1), pp.177-197.

Li, B., Stork, T., Chai, D., Ee, M.S. and Ang, H.N., 2014. Momentum effect in Australian equities: revisit, armed with short-selling ban and risk factors. Pacific-Basin Finance Journal, 27, pp.19-31.

Massa, M., Zhang, B. and Zhang, H., 2015. The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?. Review of Financial Studies, 28(6), pp.1701-1736.

Mohamad, A., Jaafar, A. and Goddard, J., 2015. Short-selling ban and cross-sectoral contagion: Evidence from the UK. Journal of Asset Management, 16(7), pp.484-501.

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