Short-selling and market efficiency

Larry Ribstein —  10 August 2011

Another day, another paper showing evidence of the negative effect on market efficiency of bans on short-selling.  Today it’s Yerkes, Regulatory Trading Restrictions, Overvaluation, and Insider Selling.  Here’s the abstract:

A contentious debate is emerging over the regulatory response to the financial crisis. This paper takes advantage of a rare opportunity to empirically test sweeping short sale constraints. Specifically, I analyze 2008 trading restrictions which prohibited short selling in all U.S. financial stocks. It is not clear whether restrictions keep negative sentiment off the market, sending prices up, or discourage ownership by stock lenders, sending prices down. It is also debatable how coincident events such as TARP affect prices, since avoiding bankruptcy is beneficial, but equity issuance and poor capitalization is not. The findings in this paper have three important implications for market participants. First, positive abnormal return and increased insider selling are consistent with an overvaluation hypothesis. The possibility of overvaluation due to TARP is ruled out since only a small percentage of restricted firms receive TARP funding and prices react negatively when they do. The overvaluation finding is consistent with prior studies of trading restrictions, such as IPO lockups. Second, additional evidence is provided on the documented relationship between institutional ownership and short sale constraints. Firms with low institutional ownership, low short interest, small market cap, and firms traded on the NASDAQ were least affected by the ban. This is relevant since 95% of stocks are not constrained by institutional ownership levels. Finally, short selling is known to facilitate information revelation and I find large declines in short interest result in less market efficiency.

Want more evidence of the efficiency effects of short-selling and the inefficiency of banning it?  Try this, this, and this. Here’s one of many posts on government’s war on the shorts (aka killing the messenger). And Bruce Kobayashi and my broader criticism of regulation of “outsider trading.”

Larry Ribstein

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Professor of Law, University of Illinois College of Law

2 responses to Short-selling and market efficiency

  1. 

    CDS stands for credit default swap, should there be any lack of clarity there.

  2. 

    The issue is that the massively opaque OTC sovereign CDS markets control sovereign debt markets.

    All sovereign bond traders follow the CDS quotes, just as all stock traders watch the S&P futures markets.

    Because these sovereign CDS markets are so thinly traded with VERY wide bid/ask spreads, this sends a false signal to the bond markets.

    Additionally, because some Eastern European CDS players KNOW of this disproportionate influence of the CDS market on underlying sovereign debt, they buy CDS running up the price AND short the sovereign debt in a VERY big way at the same time.

    This clearly creates positive feedback loops that overshoot, but the resulting panic caused by these marauding hyenas forces sovereigns to cut back massively on public health, causing untold numbers of premature deaths.

    No epdidemiologist disputes that austerity spikes morbidity. It’s in the unrebutted peer reviewed medical literature.

    However, this is rocket science to the jihadis who worship the iron fist of the invisible hand.