Would a Short Selling Ban Help—or Hurt?

During this bear market, like the last one, short selling has drawn many folks’ ire, with some arguing it exacerbates daily volatility and deepens markets’ decline. Already, some governments are taking action, with six European countries banning it for selected stocks and South Korea doing so across entire industries. Now some propose a similar ban in America. In our view, however, short selling isn’t driving volatility and it isn’t behind the drop. We think banning it is a solution seeking a problem—a move that could create issues of its own by reducing market liquidity.

Short selling is the practice of borrowing stock, selling it and (later) buying it back. If stocks fall in the meantime, you profit. Usually, this is done by hedge funds, market makers and high-frequency trading firms. Today, as in 2008, many who don’t employ this practice see it almost as profiteering—and blame it for adding to downward pressure on stocks. They claim short sellers flood the market with sell orders, stoking big daily drops fundamentals don’t justify—profiting in the process. Hence the calls to ban it. In the financial crisis, US and other regulators heeded similar calls, temporarily restricting short selling across a variety of Financials stocks. They also permanently eliminated the practice of “naked” short selling, in which traders sell nonexistent shares instead of borrowing real shares up front. So far, US regulators haven’t yet bent to pressure to ban short selling—and that is a good thing, in our view. We think the negative light so many see shorting in doesn’t really reflect reality.

In the ultra-near term, perhaps a rash of short selling could temporarily swing prices a bit. But in the longer run, we are skeptical it has much impact. For one, there is a buyer on the other side of that short sale—one who is taking literally the opposite view, no less. The number of sellers (or buyers), therefore, doesn’t dictate market direction meaningfully. The stock market is an auction marketplace in which buyers and sellers express their views about where prices are headed by bidding for stocks. In our view, treating short sellers as uniquely capable of influencing stock prices presumes their opinion is always right and ignores other market participants’ role in influencing prices.

In this year’s scenario, the sharpness and suddenness of the bear doesn’t seem that irrational or disconnected from fundamentals when you consider the fact society’s reaction amounted to slamming the brakes on an otherwise healthy economic expansion. The suddenness of that shift meant stocks had to reckon with the growing possibility of recession in a hurry. That process, which usually takes months, was condensed into a few weeks this time. Also, abnormally low liquidity—large gaps between the prices buyers are offering and sellers seeking—seemingly heightened the swings. Ironically enough, short selling can actually help assuage that.

Every short sale creates not one, but two transactions—an up-front sale and then a purchase to “cover,” or close out, the short later. Sometimes, that is mere moments later. One 2012 study by the New York Fed found market makers and high-frequency traders—together responsible for most short selling—“typically close [their short positions] within minutes or even seconds of opening them.”^[i] This means shorting typically generates a near-constant stream of buy and sell orders—not a burst of selling.

Even when short sales are held for a longer period, we don’t think they obscure fundamentals. They can actually help illuminate them. For example, some well-known hedge funds target companies they suspect of accounting irregularities. They aren’t always correct, but their opinions and analysis can help market participants identify problems. This isn’t to say they are heroes, as they are doing this for a profit. But there are market-wide benefits from the practice.

Regardless of how soon a short is covered, the existence of short sellers doesn’t prevent a stock from rising. Even stocks with high short interest—the percentage of a company’s shares currently in open short positions—can rise. If so, short sellers may rush to cover their positions in order to limit losses. Known as a “short squeeze,” this can briefly boost the stock price further. But any influence on long-term investors’ portfolios is likely limited—just like short sellers’ influence on the downside, in our view.

The ability to short stocks also enables buying that might not happen otherwise. Many short sellers are hedging other purchases. In many cases, the value of their buys exceeds the value of their short sales. Hence, it isn’t surprising many studies have found short selling doesn’t exacerbate market declines—and banning them doesn’t help markets recover. For example, the same 2012 New York Fed study concluded the US’s 2008 ban “failed to slow the decline in the price of financial stocks; in fact, prices fell markedly over the two weeks in which the ban was in effect and stabilized once it was lifted. Similarly, following the downgrade of the U.S. sovereign credit rating in 2011—another notable period of market stress—stocks subject to short-selling restrictions performed worse than stocks free of such restraints.”^[ii] British regulators also noted last week that “there is no evidence that short selling has been the driver of recent market falls.”^[iii]

In our view, markets’ anticipating rapidly deteriorating fundamentals, not trading tools, explains this bear market, and restricting short selling wouldn’t hasten its end. It is a solution seeking a problem—and one with more potential side effects than many appreciate.