In a new paper for the Cato Institute, Laurence Copeland, professor of finance at Cardiff University Business School, examines regulations on short sales.
In response to the recent financial crisis, many governments chose to ban or restrict short sales, hoping to mitigate the impact of the stock market downturn. Stock markets function as a continuous election, held to determine the allocation of resources with buyers voting for and sellers voting against investment in particular stocks. Banning short selling is akin to disenfranchising the "no" voter, thereby creating a distortion in the resource allocation process. Ban-induced price distortions damage the integrity of stock prices among investors and potentially cause stocks to expand beyond what is optimal for the firms and the economy.
Despite these costs, short sales bans continue to be pursued. Regulators often opt to ban short selling to prop up company stock prices and to increase bank depositor confidence. Large corporations and CEOs often favor short sales bans because the bans increase their companies' stock price.
But short sales bans do little to support the aims of regulators -- namely, to prop up prices and slow down stock market adjustment. As demonstrated, the motivations of corporations and CEOs to favor short sales bans are not in line with the public interest.
This paper concludes that the benefits of stock selling and buying freedom outweigh the short-run uncertain benefits of artificially propping up particular companies' stock prices and partially reducing volatility. Ultimately, capitalism requires free markets to allocate resources optimally and requires a continuous election process expressed through the demand and supply for a firm's shares, as buyers and sellers interact in the market. Restricting or banning short selling systematically biases that interaction.