The US Securities and Exchange Commission (SEC)’s ban on short-selling financial stocks has done more harm than good, according to Arturo Bris, professor of finance at the International Institute for Management Development (IMD), a Swiss business school.
In a bid to stem further declines in the value of financial stocks following a string of financial disasters, the SEC imposed a short-selling ban on 799 companies on September 19; later expanded to 883. The ban, originally intended to expire on 2 October, has now been extended until three working days after financial bail-out legislation is passed in the US (i.e. 8 October).
This follows a previous temporary restriction on so-called ‘naked’ short selling (short selling without possessing the relevant securities) of 19 financial stocks between 21 July and 12 August.
But Bris argues short-sellers provide vital information for determining the true value of a stock. “There is a group of investors that are now excluded from the market, so their information cannot be bound into prices,” he says. “The short-selling ban has made the market less liquid and less efficient.”
He adds that if there is no negative pressure on a stock from short-selling, it will keep rising unchecked, resulting in over-valuation. “The point myself and many others have made is that short sales prevent bubbles,” he said. “There is very strong evidence showing, for instance, that one of the reasons for the real-estate bubble is that you cannot short real estate.”
The SEC acknowledges that short-selling can benefit the market. “The Commission notes that short selling plays an important role in the market for a variety of reasons, including contributing to efficient price discovery, mitigating market bubbles, increasing market liquidity, promoting capital formation, facilitating hedging and other risk management activities, and importantly, limiting upward market manipulations,” reads the statement accompanying the recent ban extension.
The regulator said it had only acted to minimise what it terms ‘abusive’ short-selling: shorting a stock and then trying to manipulate the price down by spreading rumours. In a bid to limit this behaviour, the commission also strengthened its ban on naked short-selling in the latest revision of the restrictions, and is planning to make permanent the rule that stipulates short-sellers and their brokers deliver securities three days after the transaction date.
But Bris argues that if the SEC wanted to prevent price drops by discarding the benefits of short-selling, it has failed. “By banning short sales, the SEC is attempting to sacrifice efficiency to achieve stability,” he says. “I have shown that there has been a clear drop in market efficiency, but it is not clear that stability has been preserved. What you have seen during the prohibition this past week is that most of the financial stocks went down significantly, and they didn’t perform better than they did when short-selling was allowed.”
In 2007, Bris co-authored a paper with Will Goetzmann and Ning Zhu titled ‘Efficiency and the Bear: Short Sales and Markets Around the World’ which showed short-selling improved efficiency in markets where it was allowed. “What we didn’t find was that short sales induce market collapses or crashes, or that they drive stock prices down, which is the fundamental debate that is taking place now,” says Bris.
More recently, Bris conducted a study into the 19 stocks that were subject to SEC short-selling restrictions between 21 July and 12 August this year. The study found not only that that the poor performance of the stocks in the year before the ban could not be attributed to short-selling, but also that the stocks on average performed worse than the rest of the market while the ban was in place. The study found that the 19 stocks’ short interest ratios – the number of shares held short divided by the average daily trading volume – were on average no higher than those of other financial stocks in the year before the ban.
Although many have blamed short-selling for the large drops in financial firms’ stock prices, particularly those companies most troubled – Lehman Brothers CEO Richard Fuld told shareholders “I will hurt the shorts, and that is my goal” earlier this year – Bris feels short-selling has little influence over the price of a company’s shares because the short-seller has to buy back the stock to close out the short position.
Bris accepts that short-selling introduces selling pressure into the market, only to spark exactly the same buying pressure three days later. “Short sales predict market drops,” he says. “Short-sellers have better information. They are typically well-informed investors because they are sophisticated institutions.”
A more effective method of preventing volatility in certain stocks may have been to suspend them altogether. “If the solution is to limit trading then why don’t we stop trading for all financial stocks? If the objective is not to have price drops, then stop trading for those stocks for the next two months,” Bris suggests.