Facts and Fictions in The Securities Industry 1st edition

"Q: Should short-selling be allowed?

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"Q: Should short-selling be allowed?

A: Such kind of restrictions would only magnify the volatility and crisis. If a person who is bearish on the market and is not allowed to short sell, the market cannot discount the true sentiment and when more and more negative information pour in, the market suddenly slips down heavily."

But not everyone agrees. In a paper titled "The Impact of Short Selling on the Price-Volume Relationship: Evidence from Hong Kong", the authors, Michael D. McKenzie or RMIT University - School of Economics and Finance and Olan T. Henry of the University of Melbourne - Department of Economics, unequivocally state:

"The results suggest (i) that the market displays greater volatility following a period of short selling and (ii) that asymmetric responses to positive and negative innovations to returns appear to be exacerbated by short selling."

Similar evidence emerged from Australia. In a paper titled "Short Sales Are Almost Instantaneously Bad News: Evidence from the Australian Stock Exchange", the authors, Michael J. Aitken, Alex Frino, Michael S. McCorry, and Peter L. Swan of the University of Sydney and Barclays Global Investors, investigated "the market reaction to short sales on an intraday basis in a market setting where short sales are transparent immediately following execution."

They found "a mean reassessment of stock value following short sales of up to −0.20 percent with adverse information impounded within fifteen minutes or twenty trades. Short sales executed near the end of the financial year and those related to arbitrage and hedging activities are associated with a smaller price reaction; trades near information events precipitate larger price reactions. The evidence is generally weaker for short sales executed using limit orders relative to market orders." Transparent short sales, in other words, increase the volatility of shorted stocks.

Studies of the German DAX, conducted in 1996-8 by Alexander Kempf, Chairman of the Departments of Finance in the University of Cologne and, subsequently, at the University of Mannheim, found that mispricing of stocks increases with the introduction of arbitrage trading techniques. "Overall, the empirical evidence suggests that short selling restrictions and early unwinding opportunities are very influential factors for the behavior of the mispricing." - Concluded the author.

Charles M. Jones and Owen A. Lamont, who studied the 1926-33 bubble in the USA, flatly state: "Stocks can be overpriced when short sale constraints bind." (NBER Working Paper No. 8494, issued in October 2001). Similarly, in a January 2006 study titled "The Effect of Short Sales Constraints on SEO Pricing", the authors, Charlie Charoenwong and David K. Ding of the Ping Wang Division of Banking and Finance at the Nanyang Business School of the Nanyang Technological University Singapore, summarized by saying:

"The (short selling) Rule’s restrictions on informed trading appear to cause overpricing of stocks for which traders have access to private adverse information, which increases the pressure to sell on the offer day."

In a March 2004 paper titled "Options and the Bubble", Robert H. Battalio and Paul H. Schultz of University of Notre Dame - Department of Finance and Business Economics contradict earlier (2003) findings by Ofek and Richardson and correctly note:

"Many believe that a bubble was behind the high prices of Internet stocks in 1999-2000, and that short-sale restrictions prevented rational investors from driving Internet stock prices to reasonable levels. Using intraday options data from the peak of the Internet bubble, we find no evidence that short-sale restrictions affected Internet stock prices. Investors could also cheaply short synthetically using options. Option strategies could also permit investors to mitigate synchronization risk. During this time, information was discovered in the options market and transmitted to the stock market, suggesting that the bubble could have been burst by options trading."

But these findings, of course, would not apply to markets with non-efficient, illiquid, or non-existent options exchanges - in short, they are inapplicable to the vast majority of stock exchanges, even in the USA.

A much larger study, based on data from 111 countries with a stock exchange market was published in December 2003. Titled "The World Price of Short Selling" and written by Anchada Charoenrook of Vanderbilt University - Owen Graduate School of Management and Hazem Daouk of Cornell University - Department of Applied Economics and Management, its conclusions are equally emphatic:

"We find that there is no difference in the level of skewness and coskewness of returns, probability of a crash occurring, or the frequency of crashes, when short-selling is possible and when it is not. When short-selling is possible, volatility of aggregate stock returns is lower. When short-selling is possible, liquidity is higher consistent with predictions by Diamond and Verrecchia (1987). Lastly, we find that when countries change from a regime where short-selling is not possible to where it is possible, the stock price increases implying that the cost of capital is lower. Collectively, the empirical evidence suggests that short-sale constraints reduce market quality."

But the picture may not be as uniform as this study implies.

Within the framework of Regulation SHO, a revamp of short sales rules effected in 2004, the US Securities and Exchange Commission (SEC) lifted, in May 2005, all restrictions on the short selling of 1000 stocks. In September 2006, according to Associated Press, many of its economists (though not all of them) concluded that:

"Order routing, short-selling mechanics and intraday market volatility has been affected by the experiment, with volatility increasing for smaller stocks and declining for larger stocks. Market quality and liquidity don't appear to have been harmed."

Subsequently, the aforementioned conclusions notwithstanding, the SEC recommended to remove all restrictions on stocks of all sizes and to incorporate this mini-revolution in its July 2007 regulation NMS for broker-dealers. Short selling seems to have finally hit the mainstream.

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