Spillover Effect of Counter Cyclical Market Regulation
Evidence from the 2008 ban on short sales
On 18 September 2008 the SEC surprised the US financial markets by issuing an emergency order prohibiting the short selling of about 1,000 stocks of financial institutions from the NYSE, the AMEX, and the NASDAQ. Market authorities in the UK, France, Germany, and elsewhere took similar steps. The preamble to the SEC press release stated.
“The Securities and Exchange Commission, acting in concert with the UK Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence”.
The press release also attempts to justify the move:
“Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation”.
The SEC, in short, is blaming short sellers for the sharp drop in the prices of financial stocks. It suggests that these drops have little to do with fundamentals. It is no secret that the hedge fund industry was the target of this measure. And the industry–long/short equity, convertible arbitrage, and relative value managers–did indeed suffer from this disruption of its activity.
This episode comes after a period of great deregulation of short selling. By 6 July 2007 the SEC had removed some of the major obstacles, the uptick rule in particular, that had once stood in the way of short selling. This decision was made after a transition period, starting in May 2005, during which the uptick rule was removed, only for a pilot group of stocks. Diether, Lee, and Werner (2009) showed explicitly that the removal of this rule did not affect the daily returns of these stocks. Boehmer, Jones, and Zhang (2008) showed that the repeal of the uptick rule neither destabilized prices nor contributed to the great increase in volatility of the summer of 2007. These conclusions dovetail with the SEC statement that short sellers contributed to market efficiency “under normal conditions”.
Recent empirical evidence1 suggests that, on the whole, the ban had a negative impact on the returns and market quality of the off-limits stocks. In this paper, our purpose is to assess the broader impact (spillover effects) on the markets of this counter-cyclical regulation. We thus look at the impact of the ban on market indices in the US and in European markets (the United Kingdom, France and Germany) where short selling was banned. Since these indices are the underlying assets of extremely active derivatives markets (options and futures among others), it is important for both practitioners and policymakers to understand the impact of changing the rules (banning short sales) on the return distribution of these indices.
Before we summarize our empirical findings, it is useful to set up the potential effects of such regulatory action. Most of the academic literature on short selling focuses on the impact of short sale constraints on the stocks subject to these costraints. Miller’s (1977) seminal work predicts that, under symmetric information, short sale constraints will cause over-pricing, reduce volatility, and make skewness less negative.
These effects are a direct consequence of keeping the pessimistic traders out of the market. Diamond and Verrecchia (1987) have shown that, under rational expectations, Miller’s mechanism may not be at play. Rational investors will integrate into the prices the fact that traders with negative information are being kept out of the market. Recently, Bai, Chang and Wang (2006) even showed that, under asymmetric information, prices may fall, volatility may increase, and return skewness may worsen. After all, prices become less informative when short sellers are kept out of market and there will thus be less demand for the constrained assets.
Empirical evidence lends credence to the notion that restrictions on short sales will cause the stocks subject to these restrictions to suffer excessive volatility, more negative skewness, and higher kurtosis. The market quality of the stocks placed off limits deteriorates, volatility increases, and, at best, return skewness is not affected by the measure. Short sellers are thus clearly considered informed sophisticated traders2.
It seems that there are no studies that address the effects of limits on short sales that may spill over to all segments of the market. Bai, Chang, and Wang (2006), for example, develop their theory in a market where one risk-free asset (not constrained) and one risky asset (constrained) are traded. All the same, the impact of the ban on standard market indicators can be looked into and fundamental questions can be answered. Did the ban increase the overall dispersion of investor opinions? The diagnostic could be done by looking at the impact of the ban on the volatility of the indices. Did the ban curb the general market pessimism prevailing around the ban announcement?
Looking at the impact of the ban on the skewness of index returns could tell us. Finally, for the off-limits stocks, there may be configurations in which these limitations lead to a market crash.
Hong and Stein (2003) and Bai, Chang, an Wang (2006) show that, when the uncertainty as perceived by uninformed investors increases, there may be a sudden discrete drop in the prices and a subsequent huge increase in volatility. So it would be interesting to assess the impact of the ban on the tail behavior (kurtosis) of the returns of these indices.
Our empirical findings can be summarized as follows. The ban has had a considerable impact on the daily volatility of the indices. This impact is the symptom of an increase in the dispersion of investors’ beliefs about future prices. There is no evidence that this ban affected other features of the return distribution of the indices. In particular, if the markets were under downward pressure, the ban did not manage to ease it.
A reasonable conclusion is that short sellers are key figures in the financial markets. Moreover, market participants do not seem to believe that there was any particular condition that justified the measure taken by the SEC and others. Last, the hedge fund industry is certainly not to be blamed for trying to make money by exploiting the overvaluation of badly managed financial institutions.
The complete article can be found in the Winter 2011 issue of the Journal of Alternative Investments at www.iijournals.com/toc/jai/current
1 See Autore, Billingsley, and Kovacs (2009) and the references therein.
2 Ample empirical evidence confirms this. See, for example, Purnanandam and Seyhun (2009)
About Abraham Lioui
Abraham Lioui is professor of finance at EDHEC Business School. He has published widely in and refereed for leading journals and is regularly invited to the programme committee of the European Finance Association’s annual conference. His research interests in finance revolve around the valuation of financial assets, portfolio management, and risk management. His economics research looks at the relationship between monetary policy and the stock market.