Do Short-Sale Bans Really Work?

by: Christopher Holt

If there is one point of contention that still smarts like a fresh wound in hedge fund managers’ hearts it is the global crackdown among policymakers and attorneys general on short-selling.

As the world financial markets were in free-fall in the fall of 2008, the idea at the time was that, to protect banks and financial firms whose shares were on a one-way trajectory down and in turn to stabilize financial markets, ban short-sellers from continuing to bet against their shares.

From the US Securities and Exchange Commission to the UK Financial Services Authority to the states of Connecticut and Texas, short-selling was outright halted. The chart below from Hennessee Group Research illustrates the historical exposure of equity hedge funds through the end of 2008.

Since 2008 and beyond, a host of academics and other naysayers have since made clear that, aside from reducing market volatility somewhat, the bans never really worked. (For a more complete overview of the role of short sellers in the marketplace, click here.) They have further argued that the bans only served to imbalance the marketplace and reduce visibility for investors, for the simple reason that no one can truly tell how much a stock might be worth if no one is allowed to place a bet against its decline.

Yet the US Securities and Exchange Commission and other policymakers are marching forward with plans to keep short-selling bans in place, to varying degrees. The SEC last month voted to reinstate the so-called up-tick rule, though only on stocks that experience a one-day 10% decline in value. Meanwhile, Germany, Hong Kong and the European Union are all contemplating new and permanent rules on short-selling activity and disclosure.

From a practical standpoint, the billion-dollar question is how positive an impact the short-selling bans in their various forms and iterations have had on financial markets.

The original “uptick rule” was put in place during the Depression in the 1930s to prevent stocks on a downswing from being hammered by short-sellers. It barred traders from selling short, or betting that a stock would fall, unless there was an uptick in the price. The rule was abolished in 2007 by the SEC after it concluded that advances in trading strategies had rendered the rule ineffective. The new rule by the SEC essentially brings back the uptick rule, with the caveat the rule would stay in effect for only one day and lifted the day after.

According to a report on short selling published by the UK Financial Services Authority in February 2009, the UK ban did produce a “marked volatility decrease to around the still very high levels observed in mid-September before the introduction of the temporary short selling ban.” The graph below shows the volatility levels for the FTSE 350 and the financial sector from July 2008.

Source: FSA

The short answer, so to speak, is that aside from a slight reduction in overall volatility, the bans had little positive impact on the broader markets. In fact, many, including UBS Asset Management’s Alexander Ineichen (who is also a regular contributor at AllAboutAlpha.com) and Ian Marsh and Norman Niemer have argued the bans ultimately had a negative impact, by simple virtue of preventing market forces from collectively determining the appropriate value of a particular stock.

The question now is whether the SEC’s compromise – which is a cross between a short-selling ban and the former uptick rule (click here for a pithy Q&A on the new rule, courtesy of The Wall Street Journal – no subscription required) – will in some way help moderate potentially cascading declines while at the same time providing some allowances for short sellers and others to bet on a stock’s decline as they see fit.

The jury is out, but if the research is correct, the answer is it likely won’t help much at all.