Some days ago, France and Spain lifted the restrictions they had imposed on short selling (Financial Times, February 13 and February 16, 2012). Many countries had implemented similar bans in 2008 in reaction to the financial crisis. (see Beber and Pagano, Journal of Finance, forthcoming for more details).
Selling short consists in selling something that you don’t own. If you borrow the asset before selling it, the transaction is a covered short sale. If the sale takes place before stock borrowing, the transaction is a naked short. Short position can also be realized using derivatives such as forward contracts, futures or options.
Regulators and politicians tend to have a negative view on short selling. They fear that short sellers might spread false rumors and create price declines unrelated to true value.
But academics tend to have a positive view. Shorts sellers facilitate price adjustment to new information and therefore contribute to market efficiency. Short sellers also have a positive impact on liquidity. Herinckx and Szafarz (2012) confirm these findings in a recent paper. They conclude:
Overall, all short-sale regulations are detrimental to market efficiency. However, naked short-selling prohibition is the only regulation that leaves volumes unchanged while addressing the failure to deliver. Therefore, we argue that this is the least damaging to market efficiency.
Moreover, the possibility of selling short is an essential condition to rule out arbitrage. This condition underlies pricing in the derivatives industry.
Last but not least, Karpoff and Lou (2010) show that short sellers are faster at identifying financial misrepresentations than the US regulator.
To conclude, regulators should think hard before imposing new limits. The costs might be higher than the benefits. Short selling is not all bad, after all.
Beber, A. and M. Pagano, Short-Selling Bans around the World: Evidence from the 2007-09 Crisis, Forthcoming Journal of Finance
Del Marmol, Thomas, (2011), Short selling: need or fear? Impact on financial markets and implications for regulators, Mémoire, SBS-EM, Université Libre de Bruxelles, Année académique 2010-2011
Herinckx A. and A. Szafarz, (2012), Which Short-Selling Regulation is the Least Damaging to Market Efficiency? Evidence from Europe WP-CEB: N°12-002
Karpoff, J.M. and X. Lou (2010), Short Sellers and Financial Misconduct, Journal of Finance 65, 5 (October 2010) pp. 1879- 1913