A time-out on aggressive short selling in banking and financial institution stock was one of the first consequences of the recent financial crisis taking place in security markets all around the world. Both the Securities and Exchange Commission (SEC) and the U.K. Financial Services Authority (FSA) halted short selling in financial companies in order to protect the integrity and quality of the securities market as well as to strengthen investor confidence.
As a result, economists and investors have a golden opportunity to address the role short-sale constraints play in price efficiency, as well as a chance to understand better whether short-sale constraints increase the chance of market crashes.
In their paper "Price Efficiency and Short Selling," professors Pedro A.C. Saffi and Kari Sigurdsson present an invaluable study on the effects of different characteristics on the equity lending market, such as borrowing fees and lending supply on stock price efficiency.
The researchers use the data of some 17,000 individual stocks from 26 countries between June 2004 and June 2006 into the study's model, provided by Dataexplorers Ltd. This data contain over 85.7 million lending supply postings and 46.4 million lending transactions from the same period.
In the model, Saffi and Sigurdsson compute two measures of short-sale constraints: the supply of shares available as well as the fee charged to borrow these shares. By comparing weekly share price movements, the study shows that, in general, stocks with limited lending supply and high borrowing fees are associated with slower responses to market shocks, thus portraying an untrue value of the share price.
Thus, easing constraints on the equity lending market would increase the speed by which information is incorporated into prices. Additionally, the authors find that large and more liquid firms tend to have more efficient prices, while those with higher leverage or low book-to-market value tend to be less efficient.
"Whenever an investor wants to short a particular firm, he or she first needs to locate shares of the firm to borrow. Thus, a low lending supply indicates that short-sale constraints are binding more tightly, as the investor must bear higher searching costs to locate the shares," the authors write.
For that reason the authors place the greatest emphasis on lending supply statistics, which contain more information than the statistics associated with borrowing fees. The bottom line: lower levels of price efficiency are associated with low lending supply and high borrowing fees.
Fewer Constraints, Higher Efficiency
The authors then consider a third measure of stock price using the R-squared value of a market model regression. In recent years, low R-squared levels have typically been associated with better levels of governance and financial development.
However, regardless of whether short-sale constraints are associated with higher or lower levels of R-squared, the authors support the hypothesis that the difference in R-squared levels should decrease with fewer constraints.
The study checks the changes in the distribution of stock returns based on four measures: the skewness and kurtosis of weekly stock returns, as well as the frequency of large negative and large positive returns.
The study demonstrates how short-sale constraints do not seem to affect the distribution of stock returns, in particular, the frequency of large negative returns.
However, the authors highlight that these results have been found for a period without any big financial crisis. The current market conditions provide a unique environment to test the impact of these constraints and the effectiveness of regulatory measures. They are currently doing further research using 2008 events.
One of the reasons cited by regulators to impose constraints is to reduce the chances of large negative price changes. These results help dispel the myth that by removing constraints, investors are setting themselves up for a market crash.
Short-Sale Constraints and Stock Crashes
Under normal market conditions, short selling is meant to increase price efficiency as well as add liquidity to markets. What economists and professionals believe to be one of many causes of the 1929 stock market crash is today regulated by short-sale restrictions under the Securities Exchange Act of 1934.
More recently, regulators across the world - including the SEC in the United States, the FSA in the United Kingdom and the CNMV in Spain - have imposed restrictions on short-selling, saying that it was one of the reasons for the large price falls observed. The key issue here is: can short-sale constraints really lead to a market crash?
This particular study shows that while short-sale constraints hinder price efficiency, they do not affect the frequency of stock price crashes. The authors reach this conclusion after finding no significant difference in the frequency of large negative returns under varied short-sale constraints. This conclusion holds for U.S. as well as non-U.S. firms.
Since the 1930s, the extent of influence that short selling has on price efficiency has been argued on many different levels. The SEC and the U.S. government still continue to study the effect of short sales on stock prices, and passed regulation accordingly.
In 2004, the SEC considered making changes in regulation to relax short-sale constraints, launching a pilot program between May 2005 and August 2007 to help decide whether or not to remove short-sale regulation and whether any price changes are caused by short selling.
Thus, empirical studies such as this are fundamental, in order to bring about a positive change in the marketplace.
In addition, this original short-sale constraints study contributes greatly to academic literature of international stock lending markets and the determinants of lending supply and borrowing fees. "To the best of our knowledge, this paper is the first to test the impact of short-sale constraints on price efficiency at the stock level for such a wide range of firms and countries," say the authors.
Today, the SEC claims "unbridled short selling" has essentially undermined true value of securities and is to blame for sudden price declines in many of the financial institutions that are currently in dire straits.
Investor confidence is a critical element of short selling, and no other sector is more vulnerable to a crisis of confidence as financial institutions, since they depend on the confidence of their trading counterparts and their core business.
Through a better understanding of how short-sale constraints affect price efficiency, investors can better assure confidence and promote short selling, while maintaining stock prices at a closer representation of their true value.