SEC’s shorting ban 'has not achieved its goal'

The US Securities and Exchange Commission (SEC)’s ban on short-selling of 883 financial stocks, which was extended yesterday, has failed to prevent falling values, according to some market observers.
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The US Securities and Exchange Commission (SEC)’s ban on short-selling of 883 financial stocks, which was extended yesterday, has failed to prevent falling values, according to some market observers.

The SEC the short-selling ban, originally intended to expire yesterday, has been extended to one minute to midnight on the third business day after the US government enacts its planned bail-out legislation. A new bail-out plan passed the Senate on Wednesday, and the House of Representatives is expected to vote on the bill today. The House rejected the previous bill.

“By banning short sales, the SEC is attempting to sacrifice efficiency to achieve stability. Research has shown that there has been a clear drop in market efficiency, but it is not clear that stability has been preserved,” Arturo Bris, professor of finance at the International Institute for Management Development (IMD), a Swiss business school, told “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.”

He added, “I don’t think the ban has achieved its goal; it has not prevented financial stocks from going down.”

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, but did not lead to market crashes or stock price declines.

John Giesea, CEO of the US Securities Traders Association, agrees with Bris. “I don’t have any statistical evidence – just anecdotal – but it would be a shock to me if anyone could demonstrate that the short-selling ban was any help whatsoever, other than in reducing liquidity and increasing volatility,” he said. “We suggest that it is having the unintended consequence of impairing market quality rather than enhancing it.”

The ban on short sales was designed to prevent investors targeting stocks of financial sector firms considered vulnerable to collapse in the current financial crisis. But the run of bad news for the sector – including a string of bank failures, nationalisations and takeovers, and the House of Representatives’ rejection of the first US government’s bail-out bill – has made it difficult to identify the ban’s impact. Since the full-blown short-selling ban came into force on 19 September, initially covering 799 stocks, both the Dow Jones Industrial Average and the S&P 500 indices have fallen. The Dow has slipped to 10,482.85 on 2 October from 11,388.44 on 19 September, and the S&P 500 has fallen to 1,114.28 from 1,255.08 over the same period. In the UK, where there is a short-selling ban on 34 financial stocks, the FTSE 100 stock index had fallen to 4,870.30 on 2 October from 5,311.30 on 19 September – when the ban came into force.

Despite being blamed for the recent dips in financial stocks, Bris feels short-selling has little influence over stock prices. “Short-selling introduces selling pressure into the market, but it introduces exactly the same buying pressure three days later,” he said. “In that sense, I don’t think it can cause price drops. The evidence that we have is that instead, short sales predict market drops, which is a different twist. What it means is that short-sellers have better information; they are typically well-informed investors because they are sophisticated institutions.”

Although some traders and industry associations have criticised short-selling bans, the current restrictions do have some support. According to a recent study by research firm Greenwich Associates, 45% of the pension funds surveyed said that financial institutions should be able to short stocks, but 40% also supported bans.

“In times of economic stress, limiting the degree of short-selling is probably a reasonable response to ensure that markets don’t panic and become more orderly on the downside,” said Tim Lind, managing director for strategic planning at post-trade services company Omgeo. “Short-selling is a natural part of the liquidity matrix in normal market conditions. However, when we’re looking at events like the failure to pass the US financial relief package or the realisation that the values of our underlying balance sheets are a fraction of what we thought they were, it seems prudent that certain caps and limits are placed on activity.”

And while Bris thinks the US’s short-selling ban has not halted drops in share prices, he supports the SEC’s decision yesterday to extend the ban. “Given that the ban is there, I think it is the right decision to continue with it, at least until some uncertainty is removed – for example until the bail-out plan is approved,” he said.