With the recent market volatility caused by the COVID-19 pandemic, regulators across the EU and in some jurisdictions further afield have been banning short selling for varying periods. Although there are many who are sceptical of the benefits of short selling bans, several EU states including France, Italy, Spain and Austria had bans in place since March with Italy’s CONSOB opting for a ban until 18th June. Germany, along with Britain which still operates under EU rules, held back in imposing market wide bans.
In the FCA’s opinion there was “no evidence that short selling had been the driver of recent market falls”.
In Germany there was similar sentient with the BVI CEO Thomas Richter having stated, “a general pan-EU ban on short-selling for securities traded in the EU only makes sense selectively for certain companies and sectors and even then its effectiveness is doubtful.”
On Monday, the bans that were imposed by some EU regulators were suspended. Each regulator has stated that they are continuing to monitor the situation and may renew the bans should the market situation require it.
In its most basic form, short selling is an investment strategy that speculates on the decline in a stock or other security’s price. When investors engage in short selling, they are selling a security that they do not own at the time of entering into the agreement, in the hope that they can cover their positions later by repurchasing the securities at a lower price.
It can be divided into 2 types:
- Covered short selling where the seller has made arrangements to borrow the securities before the sale
- Uncovered (naked) short selling where the seller has not borrowed the securities when the short sale occurs
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Short selling bans are as the name suggests, bans on the creation of net short positions and on the increase of existing net short positions. They can be imposed on individual securities, for example last year when Bafin introduced a ban on shorting Wirecard shares, due to severe share price falls in the preceding two weeks following press reports about alleged fraud. Or, as we have seen more recently, they can be market-wide bans impacting all the shares on a market.
A great many investment and risk management strategies rely on the ability to take ‘long’ and ‘short’ positions. These benefit a wide range of ordinary investors including the pension funds for employees of companies and local government.
Whilst the effect of short selling on market prices is debated, it is generally accepted that short selling has a positive impact on market quality and generates economic benefits such as:
- increasing market liquidity;
- improving price discovery and efficiency which bolsters investor confidence
- decreased transaction costs (e.g. smaller bid-ask spreads)
- hedging against long-term investment positions and reducing overall market exposure
- exposure to both long and short positions can reduce a portfolio’s overall volatility
Many have even championed short selling for it resulting in the uncovering of cases of fraud and earnings manipulation as seen in the case of Enron and James Chanos.
An argument in favour of short selling bans (supported by ESMA), is that short selling exacerbates downward price movements, and is therefore a key contributor to increased market volatility and reduced market confidence.
ESMA also cites other risks short selling carries, including:
- settlement failures; and
- transparency deficiencies resulting in risks to financial stability, market integrity and information asymmetries between market participants
Since the onset of the financial crisis in 2008, many EU countries have taken action to suspend or ban short selling. ESMA however notes that because these were uncoordinated, it was possible to circumvent restrictions in one jurisdiction by carrying out transactions in another. They also created additional costs and difficulties for investors operating in several markets. In 2012, the EU adopted the Short Selling Regulation, which:
- increases transparency by requiring the flagging of short sales, so that regulators know which transactions are short
- gives national regulators powers – in exceptional circumstances, and subject to coordination by the European Securities and Markets Authority (ESMA) – to temporarily restrict or ban short selling of any financial instrument
- requires central counterparties providing clearing services to ensure that there are adequate arrangements in place for buy-in of shares as well as fines for settlement failure
To further the transparency, in March ESMA reduced the short selling reporting threshold to 0.1%, a decrease from the standard 0.2%.
The banning of short selling has traditionally been the subject of controversy; some consider it to be an ineffective or even counterproductive measure, whilst others consider it to be an indispensable tool at the disposal of regulators.
“We shouldn’t be banning short selling…you need to be able to be on the short side of the market in order to facilitate ordinary market trading” – Jay Clayton, Chairman of Securities and Exchange Commission
The majority of academics have concluded that banning short selling can have a detrimental impact on the market. Many have found that the bans have lowered market liquidity. One of the most referenced academic studies which consisted of daily data for 16,491 stocks in 30 countries, from January 2008 to June 2009 found that:
“Short-selling bans imposed during the crisis are associated with a statistically and economically significant liquidity disruption, that is, with an increase in bid-ask spreads and in the Amihud illiquidity indicator, controlling for other variables. In contrast, the obligation to disclose short sales is associated with a significant improvement in market liquidity.” – Short-Selling Bans Around the World: Evidence from the 2007–09 Crisis
Furthermore, it has been found that short selling bans increase trading costs – according to a whitepaper by the New York Federal Reserve, it was found that banning short selling raised trading costs in the equities and options market by more than USD1 billion between 18th September 2008 and 8th October 2008.
So, if the academic evidence doesn’t support the actions of regulators when they impose short selling bans, why do they do it?
Many suggest it is merely a symbolic gesture, during times of high volatility, regulators must be seen to be doing something, perhaps the action of imposing a short selling bans gives the impression of a decisive response.
Commenting on the most recent bans, the AMF noted that since the implementation of the ban, the Authority had observed a “progressive normalisation…markets have partly reduced their losses and the French market’s volatility index has fallen from 84 at the closing on 16 March to a level of 30 and the average daily volume on the CAC40 traded on Euronext has decreased from 12 billion euros to 4 billion”. The AMF also noted that other markets subject to short selling bans have witnessed similar findings.
However, according to the FT and data sourced from Refinitiv, during the period of the short selling bans, blue-chip indices that did not impose bans, including in the UK, Germany, Sweden and the Netherlands, outperformed markets that brought in the measures.
Whilst increased short selling activity may bode poorly for the prospects of a company, they do not appear to be the route cause of downward price movements. In turn, the justifications for imposing bans are weak and the impact of bans appear to do more harm than good with the lowering of market liquidity, the slowing of price discovery and the increase of trading costs.