Commentary

Naively Shorting the Shorts

By Chinmay Jain, Pankaj Jain and Thomas McInish
This article appeared on Real Clear Markets on August 13, 2011.

Short sellers are the pariahs of the markets. The current European financial crisis has just prompted several countries, starting with Greece, to impose temporary bans on short sales. And pressure is growing to impose a similar ban in the United States. But our statistical research of previous attempts to constrain short selling suggests that it would be a singularly bad idea.

Despite the bad publicity that short sellers receive, they earn profits just like other traders: by selling at a price higher than the purchase price. Short sellers moving against a stock can sometimes induce market panic, but they serve an important role in markets by increasing the likelihood that prices incorporate negative information about a firm’s prospects. Banning short sales, on top of the adoption of Rule 201 earlier this year is likely to do little good, and by limiting information and imposing costs, might harm the functioning of the markets.

The Securities and Exchange Commission’s new Rule 201, better known as the “alternative uptick rule,” became fully effective earlier this year. Under the rule, if a stock falls in price by 10 percent during a market day, then short sellers are prohibited from using market orders for the remainder of the day and for all of the following day. The ostensible goals of Rule 201 are to (1) prevent further decline in a stock’s price, (2) give priority to long sellers ahead of short sellers, and (3) restore confidence in markets.

The Rule, implemented at large cost, is likely to do little good, and could harm the market by removing a countervailing force to the overpricing of stock — a concern raised by several members of the financial industry and academics, including a past chief economist of the SEC.

During the financial crisis in 2008, the collapse of finance firms’ stocks provided a rich environment for short sellers. In response, the SEC temporarily banned the short selling of 797 financial stocks. Later, in February 2010, the SEC approved Rule 201 in a 3-2 vote. Unlike previous rules to regulate short selling, such as the original uptick rule, Rule 201 does not provide any exemptions for market makers or for market opening or closings. That means that when clear bad news about a stock becomes public, short sellers are limited in their ability to push that stock toward a more appropriate price.

The cost of implementing Rule 201 has been significant. Exchanges must monitor stock prices in real time and send an alert if a stock trades at a price that triggers the rule. The initial setup cost for stock exchanges has been estimated at $2 billion. Ongoing monitoring and compliance costs are estimated at $1 billion a year.

Rule 201 serves a useful purpose if short sellers are targeting stocks after a 10 percent decline. However, a recent empirical study that we conducted using data from both before and after Rule 201’s initial implementation indicates that short selling activity falls off naturally for stocks that experience a 10 percent intraday price decline. Moreover, short selling usually increases for stocks that experience positive returns, a possibility that Rule 201 completely ignores. In practice, the flat 10 percent threshold specified in Rule 201 affects many low-priced, small-cap stocks every day. However, these stocks are not the focus of short sellers. Instead, short sellers target large cap stocks that are easier to borrow.

Furthermore, our research shows that Rule 201 restricts short selling more during normal periods than during crisis periods, which is exactly the opposite of its intention. Likewise, there is no evidence of any improvement in the liquidity or valuation dynamics of affected stocks after the implementation of Rule 201.

Ideally, Rule 201 should be repealed. If not, then at a minimum, the trigger percentage should be based on the stock price and/or market capitalization rather than being a fixed 10 percent. From a trader’s perspective, a 10 percent decline in a high-priced stock is not the same as a 10 percent decline in a low-priced stock. Policy alternatives that require less monitoring should be considered. Rather than banning market orders and requiring that orders be above the prevailing best bid at the time of the order (which requires continuous monitoring), orders at a price 10 percent lower than the previous day’s close could be banned. Taiwan has a similar rule; our empirical work shows that it performs better in both normal and crisis markets. In any case, Rule 201 in its present form is both expensive and ineffective, and should not remain on the books. And whatever happens to the markets, banning short sales is not a solution.

Chinmay Jain is a doctoral candidate in finance at the University of Memphis, where Pankaj Jain and Thomas McInish are finance professors.