It's Fact - Short Sales Don't Drive Share Prices Down

At last - a piece of research has been published that examines the relationship between the level of short sales and adverse share prices.

Writing for the newly re-launched London-based Alternative Investment Management Association Journal, Emily Stewart has lead-authored the paper "Short Selling Impact on Australian Stock Prices". (Note: the author of this blog post is also a co-author on the paper).

One of the side benefits of the Australian Securities and Investments Commission's conservative approach, in which the ban on short selling was applied for an extended period compared to other jurisdictions, was that it delivered a rich data set of 127 observations.

Stewart collected the Gross Short Sales data that was published each day and applied her analysis to the S&P/ASX20, which represented almost 60% of total All Ordinaries market capitalisation. She was able to distinguish between the so-called financial stocks and the non-financial stocks, as the periods each were banned differed.

Stewart's results either debunk the conventional wisdom that declining share prices are associated with short selling or indicate that the Gross Short Sales data, for all the effort required to collect it, is a poor measure of the impact of short selling.

Short Selling Disclosure Regulations

Financial Services Minister Chris Bowen has released Short Selling Disclosure Regulations attached to the Corporations Amendment (Short Selling) Act 2008. The Regulations require that share investors report covered short sale transactions to brokers as is currently the case, and in addition, effective 1 April 2010, report positional short positions to ASIC which will be aggregated and reported with a 4 day lag.

The acknowledgement of the value of positional reporting is commendable. However, retaining the transactional reporting requirement is difficult to understand given the cost involved and in view of the fact that it is partial and misleading (see earlier post).

The announcement is silent on how the positional information is to be conveyed, whether it is direct or via prime brokers/custodians as discussed in the 6 March Treasury Consultation Paper. How will foreign investors be enforced to provide data and how will ASIC achieve the aggregation task?

All this effort and expense to justify a mechanism designed to report positions that according to the Australian Treasury represent an upper limit of 4% of total market capitalisation. Once a record of short positions is established and proper analysis is conducted will the cost of this dual reporting approach be seen to be justified?

ASIC Removes Short Sale Ban

The short selling ban on Australian listed financial securities was finally lifted by the Australian Securities & Exchange Commission (ASIC) effective 25 May 2009. The ban on financials extended beyond the two month ban placed on all securities that was lifted on 19 November 2009, because of concerns about systemic risk associoated with financial securities.

With some stability resuming in financial markets, and presumably assured by the benefit of the new reporting on gross short sales introduced on 19 November 2009, ASIC weighed up the market efficiency benefits in lifting the ban.

ASIC reserved the right to reimpose the short sale ban without consultation if they deemed it necessary. Disturbingly, ASIC referred specifically to activity by "hedge funds and similar institutions" in the same paragraph, suggesting that hedge fund activity was somehow a potential threat to an orderly market. Yet there is no such evidence that short selling does have an adverse impact on share prices, let alone that hedge funds are specifically involved in such activities.

Still on the horizon is clarification about the the form of short selling reporting that will be adopted going forward and whether the partial and potentially misleading current gross short selling regime will be persisted with.

Impact of Short Sales Restrictions on Share Prices

A recent paper by Ian Marsh and Norman Niemer dated 30 November 2008 titled "The Impact of Short Sales Restrictions" is a timely one given some governments and regulators, including in Australia, are still forming views on the appropriate regulatory approach.

The authors were expecting to see an increase in skewness and a decrease in kurtosis as a measure of whether the short sale prohibition had been effective.

They found that the imposition of short selling restrictions had no discernible impact on the behaviour of stock returns.

The analysis was limited by the small number of observations when the restrictions were in place. In Australia of course the bans were in place longer and remain in place for financials. This may make further analysis more useful.

The study highlights the extreme position adopted by Australian regulators. The following table taken from p22 of the paper shows that Australia was the only country among the 17 developed countries in the sample that banned covered short sales of non-financial stocks as well as financial stocks - see highlighted column.

SEC's Cox Regrets Short Selling Ban

US Securities and Exchange Commission (SEC) Chariman Christopher Cox said he regrets his handling of the financial crisis and in particular the banning of short selling financial stocks.

The SEC and the UK's Financial Services Authority (FSA) introduced a temporay ban on short selling financial stocks like Morgan Stanley and Citigroup on 19 September 2008. The ban was lifted on 9 October 2008.

The SEC's office of economic analysis is still evaluating data from the temporary ban on short-selling. Importantly, Cox conceded that preliminary findings point to several unintended market consequences and side effects caused by the ban, such as reduced market liquidity.

"While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again," Cox told Reuters in a telephone interview from the SEC's Los Angeles office late on Tuesday. "The costs (of the short selling ban on financials) appear to outweigh the benefits."

The SEC imposed the temporary ban under intense pressure from the Federal Reserve and Treasury Department which insisted it was crucial to the short-term survival of these institutions, Cox said.

A few weeks after the temporary ban was lifted, global markets were again dropping precipitously, U.S. banks were begging the SEC to reinstate its short-sale ban and there was talk of shutting the markets down.

Australia faced a simliar set of circumstances to the US, except that the the Australian financial sector was in relatively stronger shape. The Australian regulator, the Austrailan Securities and Exchange Commission (ASIC), was under intense pressure from Australian banks, government agencies and the press to follow the lead of the US and UK regulators.

ASIC did respond on Friday 19 September 2008 in concert with the US and UK regulators and then, remarkably, imposed a sharper regulatory response on 21 September 2008, imposing a total ban on short selling. This temporary ban on short selling was not lifted until 13 November 2008 (over a month after the ban in the US was lifted), and the ban on financials remains, with a lift being foreshadowed (but not promised) for 27 January 2009.

How will history judge Australia's policy response? Given the deeper and more protracted bans, will the unintended consequences of these actions be even greater than Cox is indicating for the US?