Sometimes the best of intentions have negative consequences
In 2008, the Securities and Exchange Commission (SEC) reactively put in place two temporary rules to constrain short sellers who were blamed for some of the patterns in stock prices during the financial crisis that began in March that year. The rules changed the way short sellers borrow stock and limited their ability to trade.
These temporary rules presented a unique opportunity to study the effect of short sellers on markets for Adam Reed, a UNC Kenan-Flagler finance professor.
As the market deteriorated in 2008, short sellers were singled out because they thrived when everyone else was losing money. Profiting while prices fell made short sellers unpopular, and the SEC slapped limits on them that greatly increased the cost of short sales. Over time, the rules came to hurt other trading, too. “Short sellers aren’t all evil-doers trying to sabotage the capitalist system,” Reed said. “I think of them as a beneficial part of market trading generally.”
In July 2008, the SEC announced an Emergency Order requiring investors in stock of a select group of 19 financial institutions to borrow or arrange to borrow the stock before trading rather than merely locating a potential lender. Before the order, investors had until three days after the trade to borrow the stock, and those who closed out their position within the day did not have to borrow at all. The order, in effect, increased the cost of short selling by requiring traders to borrow the stock three days earlier than they had previously. That increased the number of traders required to borrow, which increased demand and led to a dramatic increase in the fee charged by share lenders.
The focus was expanded to all financial stocks in September 2008, when the SEC issued a temporary ban on all short selling.
Reed and his colleagues examined the immediate and secondary consequences of the rules known as the Emergency Order and the Short Selling Ban.
Their research found that the restrictions greatly reduced short selling activity and increased the cost. Although the rules succeeded in reducing settlement and delivery failures, liquidity suffered, and stocks were slower to adjust their prices when news came out.
“We should have prices reflect information as quickly as we can,” Reed said. “It’s in everyone’s best interest. In stocks where short selling is difficult, options can trade at prices that deviate widely from their true value.”
The rules are only temporary so far. The SEC is in the process of examining a set of five proposed rules, as well as the option of taking no action. The SEC invited Reed, quoted by MarketWatch and The New York Times as an expert in short selling, to be part of its discussion in September at the Security Lending and Short Sale Roundtable in Washington, D.C. Following six months of public comment, the forum heard from select representatives of academic, industry and regulations groups. The lengthy process ensures that the consequences of a rule are apparent before the SEC decides to make it permanent.
Reed’s research concluded that restrictions on short sales changed the ratio of informed to uninformed short sellers. Sophisticated traders banned from short selling were more likely to make use of options, thus increasing the information content of short sales.
The trading decisions of an informed trader can move market prices significantly. If he sells, everyone follows suit, expecting that he knows the price is about to drop, and, if for no other reason than the rush to sell, it does. Similarly, if he buys, others rush to buy, and the price moves up.
Reed teaches business students that all stock has a market price, and that price is based on buyers’ and sellers’ valuations. For the market to work, the buyer and seller must agree on a price, but they each see the market moving in a different direction. The buyer in a short sale expects the price to go down; the seller expects it to go up. But in every trade, one of them will be wrong.
“There’s disagreement going on every minute in the market,” Reed said. “That’s basically a requirement for short selling.” As the proportion of informed traders increases, naïve traders hesitate to buy or sell because of the increased chance that they’ll be trading against someone who is more likely to be right about the direction of the stock price. That hampers liquidity, increasing the price of trades.
When the number of sales in the market is reduced, anyone who wants to buy has to bid up the price a little to attract a seller, who in this case would be a long seller. Long sellers would keep the price artificially high until the temporary ban on short selling is removed, at which point the price would fall back down again. But some investors would be buying at these temporarily inflated, incorrect prices.
“There will always be winners and losers in the stock market,” Reed said, “but it’s hard to argue that an incorrect price is better for the market than a correct price.”
Reed doesn’t object to increased SEC oversight — in fact, he’s in favor of 204-T, a permanent rule change that pertains to failure to deliver borrowed shares; and to the extent that laws already on the books aren’t enforced, that scrutiny is a good thing. But the Emergency Order and the Short Selling Ban were crafted hastily and perhaps not thought through as rigorously as many SEC rules.
“The negative unintended consequences of these two rules outweigh the benefits they might have had,” he said.
Adam Reed is the Julian Price Scholar in Finance and an Associate Professor of Finance.