Bryan Corbett, President & CEO, Managed Funds Association
As stock markets started to fall nearly a month ago, several European nations temporarily banned the short selling of shares. In the coming week, those nations must decide whether to renew those bans or let them expire. Data from this crisis and crises past make clear that they should be allowed to expire.
The initial results from bans imposed in recent weeks already point to problems: Bid-ask spreads for affected shares widened more than 15 percent compared to unrestricted shares since the imposition of the bans. That means the gap between the price at which someone will sell and the price at which another will buy grew because of the restrictions. This spread widening is effectively a tax on all investors trading the affected securities and diminishes liquidity at a time when markets need it most desperately.
Europe’s history with short selling bans provides a deep understanding of the liquidity-damaging impact of restricting short sales.
Europe’s history with such bans provides a deep understanding of the liquidity-damaging impact of restricting short sales. In 2011, several countries implemented short selling bans on certain stocks in response to the euro crisis. These restrictions on investment activity sent a message to the markets that more restrictions are likely on the way and there is reason to panic. As a result, investors de-risk their portfolios by selling, putting downward pressure on all prices.
“We shouldn’t be banning short selling” -SEC Chairman Jay Clayton
U.S. policymakers, on the other hand, have reaffirmed the importance of short selling and the downsides of banning or restricting it during the current market turmoil. In a recent interview the Chairman of the Securities and Exchange Commission, Jay Clayton, said, “We shouldn’t be banning short selling” because “You need to be able to be on the short side of the market in order to facilitate ordinary market trading.”
U.S. policymakers have reaffirmed the importance of short selling and the downsides of banning or restricting it during the current market turmoil.
The U.S. view is based on the experience of 2008, when the SEC imposed a temporary short selling ban on certain financial sector shares. Not only did the shares continue to decline in value, the SEC’s own research found the shares became more expensive to trade, as we are seeing in European jurisdictions with such bans now — further harming liquidity.
The SEC found that traders were more likely to short a stock as share prices go up, not down. That may seem counterintuitive but it makes sense. It is a trade designed to protect investors if the value of a share declines. If investors wait until the shares are already plummeting, they are not protected from the downside and the potential payoff diminishes.
Banning or restricting selling also exacerbates downward price pressures by removing one of the market participants most likely to buy as a stock declines in price: Short sellers who are buying back at the lower price to cover their trade.
Short selling restrictions also slow price discovery, a key market function, as they limit the ability of investors to react to new information. The data from the current bans in Europe bears this out — the stocks covered by short selling bans had accounted for 30 percent of total stock trading in Europe before the bans, but then trading in these shares fell so sharply after the bans that they only accounted for 25 percent of trading — with shares of retail and basic materials companies hardest hit by the declining volumes. And volatility in trading of restricted shares was, and remains, 11 percent higher than shares not covered by the bans.
In times of turmoil, policymakers look for any and all answers. It’s a reality I am very familiar with from my time in the White House and the U.S. Treasury. Frequently, their starting point is the past.
Over the past month U.S. and EU policymakers have refreshed a range of tools developed during previous crises. Some of these steps — such as adding liquidity and reassuring investors markets will remain open — have helped bring some stability. Evidence suggests that short selling bans have only added chaos and dysfunction.
There is one overarching reason why Europe should discontinue short sale bans — the EU’s effort to establish a Capital Markets Union. No capital market can thrive without the ability of investors to make their own decisions on whether the value of a stock should rise of fall. That means not banning short sales.
For all of these reasons, policymakers should let the bans expire. Additional country-specific bans — or an EU-wide ban — would increase market turmoil in Europe and harm investors.
For more information on how short selling benefits healthy capital markets watch the video below and visit hedgefundamentals.org/shortselling
Bryan Corbett is the President & CEO of Managed Funds Association. He was previously a Partner at The Carlyle Group and served as a Special Assistant to the President for Economic Policy and as the Senior Advisor to Deputy Secretary Robert Kimmitt at the Treasury Department. He also served as Majority Counsel on the Senate Banking Committee.