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Short selling regulation after the financial crisis – First principles revisited

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Abstract

This article examines the recent regulatory developments with regard to short selling. Short selling regulation is an important factor in firm governance because it affects the way in which firms are subject to market discipline. As the financial crisis has attracted regulators’ notice to short selling once again, it is important to understand the fundamental legal and economic arguments regarding short selling. These arguments have at their core the question of whether there exists a market failure. The available evidence on balance suggests that short selling restrictions hamper the price discovery process. Also, while regulations against market abuse are required, it is often an ineffective detour to pursue the goal of fair markets through the regulation of short selling. On the basis of these arguments, the article evaluates the approaches taken by the US and UK regulators, who play a leading part in the current movement towards more comprehensive short selling regulation. The US Securities and Exchange Commission's (SEC's) recently adopted rules do not seem to bring much added value and will presumably affect market efficiency in the negative. First principles suggest a somewhat more positive stance on the SEC's proposal for a circuit breaker rule and the UK. Financial Services Authority's proposed disclosure approach, though both are subject to caveats. We also highlight some central questions for future research.

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Notes

  1. For a detailed and regularly updated overview of the emergency short selling bans and other regulatory constraints imposed on short selling in the course of the financial crisis and beyond, see Gruenewald et al (2009).

  2. The focus of this article is on how regulators should approach the regulation of short selling in the long term. The ex post evaluation of the emergency restrictions adopted during the crisis could provide important (additional) evidence. However, analyzing the restrictions’ causal effects is as interesting as it is challenging. From the methodological perspective, note that, to estimate the price, liquidity or volatility effects, the central question is what would have happened (with the affected stocks as well as with the markets as whole) in the absence of the emergency regulations, which is difficult to ascertain empirically. In particular, the fact that the stock market overall did not recover for a fairly long time and, indeed, kept falling even with the emergency restrictions in place is, in and of itself, not evidence of a lack of effectiveness of the restrictions. To our knowledge, Beber and Pagano (2009) provide the most comprehensive international analysis of the effects of emergency short selling restrictions adopted during the financial crisis of 2007–2009.

  3. Similar hedging techniques also exist in commodities markets (especially commodity futures). This article, however, focuses on short selling of stocks.

  4. Traders often hold their securities in street name to use them as collateral for margin loans and to ensure that they are available for settlement.

  5. Legally speaking, stock lending is actually more akin to a sale and redelivery than to borrowing as such.

  6. As Harris (2002), at page 157, notes, the reluctance of brokers to pay the rebate to their retail clients is surprising. Those brokers willing to pay out only half the interest they receive as short interest rebate should have an extremely lucrative business.

  7. See Hu and Black (2006, 2007) for a review of these issues. Starting from the benchmark result on the optimality of the one-share-one-vote rule (Grossman and Hart, 1988; Harris and Raviv, 1988), researchers have considered the notion that a decoupling leads to increased rent extraction (Bebchuk et al, 2001), and also to the ability of firms to make long-term investments whose expected payoffs are hard for outside investors to assess (DeAngelo and DeAngelo, 1985). This research has suggested, owing to a wedge between the individual and social value of voting power, both that some may acquire excessive power without paying an appropriate price for doing so (Hu and Black, 2007) and that a control contest for votes could have efficiency advantages, compared to a contest for shares (Blair et al, 1989).

  8. Solutions to this problem do not yet exist, as it is an utterly new phenomenon of the recent financial crisis that prime brokers actually collapse.

  9. The practice of buying-in is found in most jurisdictions, but the precise form varies. Some clearing agencies even provide for automatic buy-ins in case of fails to deliver.

  10. See Lamont (2004) for a description of battles between firms and short sellers over short selling.

  11. Interestingly, the SEC has implicitly used this kind of moral reasoning to justify its latest restrictions on short sales. It has argued, for instance, that short selling may ‘deprive shareholders of the benefits of ownership’ (SEC, 2008b, p. 3). Although this is of course true, it is not a specific problem of short selling, but rather of non-fulfillment of contractual obligations in general. If non-fulfillment occurs deliberately, it is not only considered undesirable, but also immoral. By implicitly relating deliberate (or at least accepted) non-fulfillment to short selling, the SEC thus creates – at least in this context and perhaps inadvertently – the appearance of denouncing short selling (especially naked short selling) as an unethical practice.

  12. For a compilation of legal-normative reasons for financial regulation see, for example, Arner and Weber (2007).

  13. Another rationale for regulation would be a market absence, that is, the situation where there is no effective market at all (for example, monopolies).

  14. The so-called Public Interest Theory assumes that regulation is implemented solely to correct market failures. This theory is challenged by the Capture Theory and the Economic Theory of Regulation, which are both based on the assumption that regulation is the result of pressure groups pushing their particular interests (see, for example, Stigler, 1971).

  15. On an even more general level, economists have provided a number of conditions under which there is scope for welfare-improving restrictions on private contracts (see Hermalin and Weisbach, 2006). In particular, regulating private contracts can be welfare-enhancing if (i) there is asymmetric information between the parties at the time of contracting (see Aghion and Hermalin, 1990); (ii) the contract between the two parties has an externality on a third party (see Aghion and Bolton, 1987); or (iii) the courts can impose a remedy or penalty not available to the parties privately. Indeed, Hermalin and Katz (1999) establish that these are the only three possible cases in which outside interference in private contracting has the potential to be welfare improving when agents are rational.

  16. While investors taking long positions are normally reluctant to reveal information to the market and keep their cards close to their chests, it is questionable whether short sellers are equally incentivized to keep their short positions a secret. Short sellers may actually have an interest in making their positions transparent to other traders since this may increase strategic behavior and eventually produce higher profits.

  17. Bekaert et al (2002) emphasize the importance of speculators particularly in emerging market efficiency.

  18. Jones and Lamont (2002) use a data set from 1926 to 1933. Data on today's lending fees are much harder to find than for this period of time.

  19. To address concerns about unobservable differences between international markets, Bris et al (2007) also carry out an event study to analyse changes in short sales regulation in five countries in their sample (Hong Kong, Malaysia, Norway, Sweden and Thailand). In line with their earlier results, they find that removing restrictions on short sales leads to gains in efficiency.

  20. This is also consistent with the findings of Marsh and Niemer (2008), who did not find evidence that restrictions on short selling changed the behavior of stock returns.

  21. This finding of an adverse impact of the short selling ban on liquidity is consistent with the evidence in Clifton and Snape (2008).

  22. A third scenario would be that an investor, intending to buy stocks of a specific company, spreads negative rumors to beat down the price.

  23. This is also important because some have argued that short selling can contribute to efficient price formation by substituting for failing governance mechanisms inside the firm. Karpoff and Lou (2008) study short selling in firms that are subsequently found to have misrepresented their financial statements. They show that short sellers anticipate the eventual discovery and severity of financial misconduct. Short selling thus conveys external benefits to uninformed investors. However, it appears that limits on this channel of information transmission arise from the potential for manipulative activity.

  24. Bris et al (2004) find that in markets where short selling is prohibited or not practiced, market returns display significantly less negative skewness. However, at the individual stock level, short sales restrictions appear to make no difference in this dimension.

  25. For example, a speculator may know that a target firm has a covenant on its debt contracts that stipulates that when the stock price falls below a certain level, the debt is due immediately. This will jeopardize the survival of the firm. Thus, a speculator has an incentive to aggressively short this stock. But proving that this is a manipulative act will be very difficult.

  26. For initial public offerings see Edwards and Hanley (2008).

  27. Indeed, these results are not statistically significant for the shelf-registered offerings, which are less susceptible to manipulative trading as potential investors are generally not aware of a shelf-registered offering until immediately before its occurrence.

  28. 17 C.F.R. §242.105.

  29. Of course, if all short selling activity – including the identity of the short seller – were transparent to the market, the particular company could exclude investors who are short from the allocation of offering shares.

  30. Not all options are tradable; major shareholders also write over-the-counter (OTC) options.

  31. A short position can also be taken through spread bets, contracts for difference (CFDs) and total return swaps.

  32. For example, in 1785, France released a royal decree against future selling of what one did not own, and futures markets were forbidden. One year later, a study found that free brokers had discovered means to evade this regulation through prearranged cancellation of contracts (Meeker, 1932, p. 218).

  33. By contrast, synthetic short sales are suitable for ‘secret’ short selling. Chesney and Mancini (2007), for instance, find that the open interest on option volumes during the days before the terrorist attacks of 11 September 2001 were atypical; for example in the case of American Airlines, the amount of put option contracts traded on 10 September 2001 was more than 60 times the average of the total daily traded volumes during the three weeks before that date. Informed insiders would not have wanted the market prices to adjust already before 11 September 2001.

  34. Of course, the rules against manipulation apply for both.

  35. At the international level, the International Organization of Securities Commissions recently issued a report outlining non-binding high-level principles for the regulation of short selling designed to assist domestic regulators in their consideration of a regulatory regime for short selling (IOSCO, 2009). A pan-European approach in short selling regulation is proposed by the Committee of European Securities Regulators (CESR) in a recent consultation paper (CESR, 2009).

  36. Broker-dealers engaged in bona fide market making are exempt from the ‘locate requirement’ as they may be required because of their market making obligations to facilitate customer orders in fast-moving markets without delays caused by compliance with Regulation SHO.

  37. The terms ‘participant’ and ‘clearing agency’ may be drawn from Sections 3(a)(24) and 3(a)(23) of the Securities and Exchange Act, respectively.

  38. Critics of the Naked Short Selling Antifraud Rule had argued (i) that the SEC should have taken stronger enforcement action under the previous federal securities laws rather than adopting new rules; (ii) that the new rule is generally unnecessary since previous regulation already provided the SEC with the necessary authority to address manipulative and fraudulent activities; and (iii) that less formal means than rulemaking, such as speeches or bulletins, should have been used to address the SEC's concerns (see SEC, 2008a, pp. 21–22).

  39. In its release on the Amendments to Regulation SHO, the SEC also provided additional guidance in terms of bona fide market making for purposes of complying with the market maker exception to the locate requirement of Rule 203(b)(1). This rule determines that brokers or dealers may not accept or effect a short sale in an equity security unless it has first borrowed the security or entered into a bona fide arrangement to borrow the security or has reasonable grounds to believe that the security can be borrowed in time.

  40. According to Rule 203(c)(6), the term ‘threshold security’ means any equity security of an issuer that is registered pursuant to Section 12 of the Securities and Exchange Act or for which the issuer is required to file reports pursuant Section 15(d) of the Securities and Exchange Act: (i) For which there is an aggregate fail-to-deliver position for five consecutive settlement days at a registered clearing agency of 10 000 shares or more, and that is equal to at least 0.5 per cent of the issue's total shares outstanding; (ii) that is included on a list disseminated to its members by a self-regulatory organization.

  41. For an analysis of the link between fails to deliver and option markets in the regulatory environment of the previous version of Regulation SHO see Evans et al (2009). See Boni (2006) for a description of the earlier regulation.

  42. Under certain circumstances, the new rule provides additional time during which fails to deliver can be closed out; for example, fails to deliver that are attributable to bona fide market making activities by a registered market maker, options market maker or other market maker obliged to quote in the over-the-counter market need to be closed out by T+6. Furthermore, provided that the allocation is reasonable, the close-out requirement applies to registered brokers or dealers that were allocated the fail-to-deliver position from the participant, not to the participant directly.

  43. While suggestive, the Office of Economic Analysis does not causally identify the effect of the new rules. In particular, they do not consider the fact that short selling restrictions reduced the level of short selling and, thus, most likely also of fails to deliver.

  44. Additional short selling restrictions are provided for in the ‘Wall Street Reform and Consumer Protection Act of 2009’ (H.R. 4173) in the version approved by the House of Representatives, including, among others, the obligation of brokers and dealers to inform their customers that they may elect not to allow their securities to be used in connection with short sales.

  45. With this supplemental proposal, the SEC extended the comment period until 21 September 2009. A feedback statement has not (yet) been released.

  46. Existing circuit breakers focus on market indexes, not on markets for individual stocks, and thus apply a market-wide trading halt (SEC, 2009b, p. 89).

  47. SEC Rule 240.10a-1, 17 C.F.R. §210.10a-1.

  48. Another implication of the uptick rule, relevant for research in finance and economics, was that short sales were misclassified as buyer-initiated by Lee and Ready (1991) and other commonly used trade classification algorithms (Asquith et al, 2008).

  49. Since a ban on short selling, even if it is of a temporary kind, rather produces a market failure than reduces it, we prefer the less radical alternative of the short sales price test.

  50. It is also conceivable to consider the level of short selling itself as an indicator on which to base contingent regulatory action. A formal optimal stopping model might shed light on the optimal timing decision for the regulator.

  51. The SEC proposes the circuit breaker rules to impose the halt or price test restriction until the close of the consolidated system (SEC, 2009b, p. 141).

  52. The FSA had already announced to consider amplified transparency requirements for short selling in an earlier document (FSA, 2009a).

  53. It is questionable, however, how the FSA intends to monitor and enforce the disclosure of short positions taken through these instruments in practice.

  54. In a feedback summary, the FSA concluded that its approach is strongly supported (FSA, 2009c). However, with a view to international and regional initiatives on short selling still ongoing (CESR, 2009; IOSCO, 2009), the FSA has so far abstained from publishing any proposed rule.

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Acknowledgements

This research was supported by the University Research Priority Program ‘Finance and Financial Markets’ of the University of Zurich, Switzerland, the NCCR FINRISK and the Swiss Finance Institute. We thank Michael Alles (the Editor), an anonymous Referee, Marc Chesney, Jean-Charles Rochet, and Urs Waelchli for comments and suggestions. All errors are ours.

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  1. University of Zurich, Plattenstrasse 14, Zurich, CH-8032, Switzerland

    Alexander F Wagner

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  1. Seraina N Grünewald
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  2. Alexander F Wagner
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  3. Rolf H Weber
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Correspondence to Alexander F Wagner.

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Grünewald, S., Wagner, A. & Weber, R. Short selling regulation after the financial crisis – First principles revisited. Int J Discl Gov 7, 108–135 (2010). https://doi.org/10.1057/jdg.2010.2

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  • DOI: https://doi.org/10.1057/jdg.2010.2

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