Open Platform: Short Sighted on Short Selling

During the early stages of the financial crisis, politicians pulled every plug and threw every switch that they thought might help to stabilise banks. As part of this process, several European countries imposed bans on the short selling of shares in selected financial institutions (FIs) and credit default swaps (CDSs) for Euro-area bonds.

The SEC first banned short selling on the stocks of big FIs in the week after Lehman Brothers collapsed back in 2008. Aggressive short selling was said to have pushed the bank's share price down prior to its bankruptcy.

Similarly, many European national regulators perceived short selling to be a threat to the value of their banking assets and government bonds, at a time when the markets needed certainty and strength. A range of different measures were implemented, but typically for fixed periods of time naked shorting was banned for specific stocks. The bans have been renewed and adapted frequently throughout the ongoing financial crisis.

Pressure from both national regulators and politicians led to the drafting of a Europe-wide ban on naked short selling for stocks and CDSs, with the requirement for firms to disclose their short positions to regulators if they held more than 0.2 percent of the issuers' capital and to publicly disclose a holding of 0.5 percent or more. The European Securities and Markets Authority has put together the technical standards for these rules, which come into effect today, and has recently conducted a consultation on exemptions for market makers and authorised primary dealers, with guidelines likely to be published this month.

Liquid Shock
Some national regulators have pre-empted this, with the Spanish and Italian regulators the latest to flex their muscles on the matter, banning short selling (naked or covered) in their respective markets in July this year.
However, 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. Thus, it delivered nothing it intended to.

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?

Similarly, consulting firm Oliver Wyman published a study in 2011 on the effect of disclosure regimes which indicated that liquidity and trading volumes were considerably suppressed in stocks with public disclosure regimes compared to stocks without.

While some of the national regulators have frequently introduced these bans overnight, the Europe-wide ban has at least been given due process. Still, 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 a business solutions architect at Fidessa. The opinions expressed are those of the author, and do not necessarily reflect those of Waters magazine or Fidessa.