Blame Ban on Short Selling for Market Volatility

Don't blame short sellers - blame the ban on short selling for adding to an already volatile stock market, European finance experts said this week.

Academics at the EDHEC-Risk Institute, a leading European business school, blasted financial regulators in France, Belgium, Italy and Spain for imposing or extending short-selling bans in the wake of renewed market volatility. They say they've documented the positive contribution of short-sellers to market efficiency.

In fact, their studies have shown that constraining short sales significantly reduces market quality by reducing liquidity and increasing volatility and can have unintended spillover effects. "These hasty decisions are not only devoid of theoretical basis, but also fly in the face of empirical evidence," a professor at EDHEC Business School, Ekkehart Boehmer, said.

In a series of research articles, Boehmer and his co-authors studied short selling activities, looking at the type of information possessed by short-sellers, at the impact between short selling activities and abnormal returns , and at the link between short-selling and the price discovery process .

What they discovered is fascinating: They established that short sellers are important contributors to efficient stock prices and that short interest contains valuable information for the market. Plus, that information is impounded faster and more efficiently into prices when short sellers are more active and short sellers change their trading around extreme return events in a way that aids price discovery.

The EDHEC Business School professors also looked at the consequences of the previous short-selling bans imposed in America, the UK and continental Europe in 2008. The study led by Professor Boehmer concluded that stocks subject to the ban in the United States suffered a severe degradation in market quality, as measured by spreads and price impacts, and intraday volatility.

A recent study by Professor Abraham Lioui focused on the impact of the bans on leading market and financial indices in America, France, the UK and Germany and found that these led to a systematic increase in the volatility of market indices and had an even stronger impact on financial indices. None of the studies found indication that short-selling bans reduced downward pressure in a significant manner.

Against this backdrop, EDHEC-Risk Institute denounced the decisions to impose or extend short-selling bans as a political smokescreen that is likely to be counterproductive, both directly by disrupting market functioning and degrading market quality at a most testing time.