Bid-ask spreads widened and trading activity concentrated around the market open and close for large European equities following restrictions on short-selling of financial stocks, according to an analysis by Credit Suisse Advanced Execution Services. In a parallel report on the now-lifted US ban on short-selling, the bank said “across the board” falls in liquidity levels had increased volatility and impact costs.
Credit Suisse’s study of trading patterns before and after the 19 September implementation of the UK Financial Services Authority’s new rules on short-selling shows that bid-ask spreads increased 12% from 17.7 basis points to 19.9 bps for restricted stocks with a daily turnover in excess of €5 million, while daily turnover fell 7.5% to $7.45 billion. But bid-ask spreads for liquid European stocks not subject to short-selling restrictions widened even further, registering a 14% increase from 9.73 bps to 11.08 bps, while turnover remained broadly stable.
In addition, the analysis revealed that trading activity within 30 minutes of market opening accounted for 11.5% of total daily volume in restricted stocks compared with 9.8% before the ban. Similarly, trading after 16.00 represented 23.8% of daily volume after the ban, versus 20.2% beforehand. Noting an increased concentration of activity at the beginning and end of the trading day in both restricted and unaffected stocks, Credit Suisse said, “there seems to have been a flight to liquidity as more investors decide to trade in the closing auction”.
Credit Suisse observed that although the short-selling ban “probably” changed the micro-structure of the European markets by reducing the number of potential sellers of restricted stocks, “higher risk aversion” was affecting “the entire market”. The bank’s study compared trading from 1-29 September in non-restricted components of the DJ Stoxx 50 index with that of large-cap stocks subject to short-selling restrictions from Benelux, France, Germany, Ireland, Spain, Switzerland and the UK.
Although restrictions on short-selling have been introduced by Europe’s national regulators at different times, Credit Suisse identified the UK regulator’s 19 September ban as having had “the largest impact” on Europe’s equity markets. The FSA banned short-selling in 29 financial stocks until 16 January 2009, subject to review 30 days after the ban’s introduction, citing the need for financial market stability.
Credit Suisse said that the restrictions may have curbed some aggressive selling in European financial stocks, but added the impact of regulatory change had been “dwarfed by the continuous negative news flow”. The bank’s analysis also suggested that the bans risked undermining their aims of market stability through their impact on volumes and subsequently volatility. “The ban on short-selling has also removed the ability to hedge execution by going long/short an appropriate portfolio of stocks that would involve shorting the financial sector. The ban has effectively pulled the plug on a number of trading techniques incorporating this, resulting in lower intraday volumes,” the report said.
In a separate study of the impact of short-selling restrictions in the US, Credit Suisse said that a “dramatic drop-off in volumes” was having a “harmful” impact on trading costs. “With less volume, smaller trades that would otherwise have been absorbed with little impact now have more potential to move the market – thereby creating high impact costs and increased volatility,” the analysis stated.
The fact that volumes had decreased “across the board” as many hedge funds opted out of either long or short trading suggested that any future reintroduction of short-selling restrictions to protect other sectors would have similarly widespread consequences.
“Although the restriction only applied to certain stocks, continuing to trade stocks outside the list would create skewed exposures with undesirable holes where [the hedge funds’] models would otherwise call for exposure to restricted stocks. We might, therefore, expect a similar outcome any time a significant portion of a trader’s universe is off-limits,” Credit Suisse said.
In its US analysis, Credit Suisse said bid-ask spreads in the 950 stocks protected by the Securities and Exchange Commission’s restrictions on short-selling from 18 September to 8 October were “substantially” wider than prior to the ban. Credit Suisse said the average bid-ask spread for the securities subject to the restriction widened from a 2008 average of 17 basis points to around 40 basis points in the week beginning 22 September, further expanding to almost 60 bps by the end of the restrictions.