Why do regulators think that banning short selling is the answer?

In spite of repeated research proving that short selling bans hurt markets rather than help them, some global regulators insist on continuing short selling bans to help banks or other select “beneficiaries.” The evidence against these bans couldn’t be stronger. To make matters worse, random short selling bans serve to undermine confidence in publicly traded markets, which in turn hurts national economies.

The latest criticism against short selling bans comes from the Federal Reserve Bank of New York in a research note (Market Declines: Is Banning Short Selling the Solution?). The authors show their findings that “short selling does not appear to be the root cause of recent stock market declines. Furthermore, banning short selling does not appear to prevent stock prices from falling when firm-specific or economy-wide economic fundamentals are weak, and may impose high costs on market participants.” These findings echo others, particularly well-cited reports from EDHEC-Risk and professors Alessando Beber and Marco Pagano.

In sum, short selling bans:

– Damage confidence
– Reduce liquidity, which increases investor costs
– Don’t actually solve the problem of lowering stock prices
– Impair price discovery, which is what publicly traded markets are supposed to be there for to begin with

An important question here is why do short selling bans get brought out when markets go sour? It may be that in a world with fewer regulatory options, banning short selling is one of the levers that regulators can pull with little concern of a major political push-back. Short selling continues to have a negative stigma attached to it in the public eye (betting against success seems just mean), although in modern finance short sales are made for very diverse purposes including risk hedges and market neutral strategies.

There may also be some conceptual overlap between banning short selling and implementing new circuit breakers, although such thinking would be in error. While circuit breakers also limit liquidity, they do so on an expected, predictable basis. Circuit breakers provide certainty to market participants whereas short selling bans do not.

It seems to us that there are two conflicting issues with recent short selling bans: market regulation and political gamesmanship. The two are not compatible, and the latter does not produce the final result that “regulators” are hoping to garner, which is the overall improvement of stock market prices and economic growth.

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