The Securities and Exchange Commission (SEC) recently scored a significant win against a Maryland banker accused of naked short-selling. What may be good news for the SEC is bad news for the market, as the SEC will now be more likely to persecute other alleged offenders of naked short-selling restrictions.
“Naked” short selling is when a trader sells stocks the trader doesn’t actually own (and doesn’t borrow in a prescribed period of time) in the hopes of buying the stocks later (before they must be delivered) at a lower price. The trader is basically betting that the stock price will decline. If it doesn’t, the trader must purchase the stock at a higher price–or breach their original sale contract.Some critics argue that such short-selling leads to market distortions and potential market manipulation, and some even pointed to short-selling as a boogey-man in the 2008 financial crisis, hence the restrictions on short-selling giving rise to the SEC’s enforcement proceedings.
Just one problem, there’s a lot of evidence that shows restrictions on short-selling make markets less efficient, not more.
This isn’t exactly news. Thom argued against short-selling restrictions seven years ago (here) and our late colleague, Larry Ribstein, followed up a couple years ago (here). The empirical evidence just continues to pile in. Beber and Pagano, in the Journal of Finance earlier this year examine not just US restrictions on short-selling, but global restrictions. Their abstract reads:
Most regulators around the world reacted to the 2007–09 crisis by imposing bans on short selling. These were imposed and lifted at different dates in different countries, often targeted different sets of stocks, and featured varying degrees of stringency. We exploit this variation in short-sales regimes to identify their effects on liquidity, price discovery, and stock prices. Using panel and matching techniques, we find that bans (i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options; (ii) slowed price discovery, especially in bear markets, and (iii) failed to support prices, except possibly for U.S. financial stocks.
So while the SEC may celebrate their prosecution victory, investors may have reason to be less enthusiastic.
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Since the financial crisis, the SEC has instituted a variety of regulations to protect investors. Similar to the Frank Dodd Act, the SEC is out to catch anyone potentially taking advantage of current market conditions and trading loopholes. The next question to ask is how much regulation is too much regulation and is that in turn handicapping our free market economy?
Regulation SOH doesn’t restrict short selling; it just makes sure that the transaction can be completed; that is, that the short-seller can actually buy/replace the stock at a lower or higher price, whichever that might be.