Whenever there was a market place, there was a short seller. The nature of short selling in American stock markets is simple; you are investing against the nature of the market. Many in the investment field have strong opinions on short sellers; they’re either beneficial or detrimental to the market system. This topic is controversial because short selling can be dangerous, yet it is still important in a stock market. Short selling bans have existed in the United States during financial crises, and temporary short bans exist on individual stocks after earnings reports or unusually high volume on an individual stock. Short selling bans do not constitute a negative or positive correlation in security pricing and therefore lifting short selling bans increases price efficiency and promotes ethical investigations into corporations.
First, short selling promotes price efficiency. Price efficiency is crucial to a stock market, because it allows equilibrium in the market place. Price discovery is promoted with short selling because there is an increase in efficient sellers in the marketplace. Research using econometric analysis of 17,000 stocks from over 30 countries during short selling bans from January 2008 to June 2009 found a significant increase in bid-ask spreads, according to the Center for Economic and Policy Research (CEPR) (Beber and Pagano 1). These increases in bid-ask spreads slowed down price discovery in certain securities. Specifically small capitalization stocks, high-risk securities as well as low volume securities felt the negative consequences of short bans due to a decrease in price efficiency. This is because the short selling bans created an increased discrepancy between the bid-ask prices. This inefficiency decreases price discovery and promotes equilibrium in the market place because of the difficulty of finding the right price to trade at. According to Capco Institute’s Journal of Financial Transformation, “[s]hort selling improves the dissemination of information about stocks, it enhances the price discovery process, and as consequence markets are more liquid and less volatile” (Pais and Stork 35). While there is a correlation between increased bid-ask spreads and short bans, when short bans are lifted, bid-ask spreads decrease and a closer equilibrium in the market is met. This is an important concept that short selling promotes and without short sellers would not be achieved.
Another point is that short selling bans do not work. According to the CEPR research, “results do indicate that the bans have not been associated with better stock performance” (Beber and Pagano 1). The research compared the median aggregate post ban performances of securities to stocks without a ban in place, using market indices as benchmarks. The extensive CEPR research explains how performances are not related to short bans, which is the main purpose of short bans, to effect stock performance. An Oxford Journal study by Dr. Saffi at Cambridge Judge Business School gathered a dataset of over 12,600 stocks from stocks internationally between 2005 and 2008 and concluded that relaxing short-sale constraints is not associated with price instability or extreme negative returns (Saffi 1). Short selling bans are in place because the U.S. Security and Exchange Commission (SEC) fears that short selling is what causes sharp declines in a stock’s price and put bans in place to return stability. This is not the case according to Dr. Saffi at Cambridge and his study that demonstrated how extreme negative returns and price instability are not correlated with short-sale constraints. Even a publication by the Federal Reserve Bank of New York shows stock prices stabilize once bans are lifted from the stock. Intriguingly, stocks subjected to short-selling constraints perform worse than stocks free of such constraints (Battalio, Mehran, and Schultz 5). This publication reaffirms the CEPR research and Oxford Journal study by stating the short-selling bans do not affect performances in the way that were intended to by the ban, therefore concluding the bans do not work. The research done by CEPR, the Federal Reserve Bank of New York, and the Oxford study show relaxing short sale bans do not drastically affect a stock’s price or influences a stock’s instability, and stocks with short-selling constraints perform worse than stocks free of such constraints. Those studies help conclude the fact that short selling bans do not work.
Finally, short selling promotes investigative journalism and business ethics. The ability to short a company is the ability to check a company, a check that anybody in the outside world could perform. According to American Journalism Review, Christopher Carey, a writer for an investigative journalism website, wrote an article about the questionable technology Xethanol Corp was using (Spivak 39). The stock ended up falling 20% after the article. This isn’t the only case of investigative journalism profiting from short selling. Xuhua Zhou, who dropped out of UCLA’s doctoral program in finance, learned Lumber Liquidators sourced products in his home country of China. He dug into the safety concerns and learned the distributors were curbing key safety regulations, which were highlighted on CBS News’ 60 Minutes (Townsend 1). There have been many stories about investors who investigate companies and can benefit on promoting the correct business ethics and standards. Investors who could find enough evidence to show that a company’s ethics are questionable have a financial incentive to research the company and find ethical flaws. This is a favorable advantage to short selling and shows how through research of companies operations, can find flaws and invest on them.
In conclusion, there is a persuasive argument into why short selling bans do not work. The studies that have been cited are not definite but there is major evidence in supporting the idea of keeping short selling constraints out of the market place. Short selling can be dangerous but carries many benefits like increase price efficiency and promotes investigative journalism. Invest with care.
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