The evolution of short selling regulations and trading practices

1. The evolution of short selling regulations and trading practices Chinmay Jain Pankaj K. Jain Thomas H. McInish University of Memphis

2. Reading Questions • Define short selling. • What are the pros and cons of short selling? • How have the short selling regulations changed over time? • Are short selling regulation changes successful in achieving the desired goal? • Which aspects of short selling regulations hamper price discovery process? • Describe the historical experience about regulatory action regarding short selling following crises? • Characterize the changes in outstanding short interest before and after the recent financial crisis and in the periods surrounding the temporary regulatory ban on shorting. • How does short selling ban affect stocks with varying levels of dispersion of opinion? • Define fails to deliver in the context of short selling. Describe fails to deliver patterns during the last 5 years. • Provide the details of the current short selling rules in the U.S.

3. Short selling • Borrow and sell a stock today without actually owning it • Buy back the stock in the future and return to lender • Gains or losses of short seller are based on the difference between selling price and buying price • No capital gain or loss to lender who continues to own the stock throughout

4. Advantages and disadvantages of short selling • Advantages • Efficient pricing in stock markets in presence of short sellers with negative information • Short sellers can align the stock price with fundamental value • Disadvantages • Predatory short selling can push the stock price below fundamental value

5. History of short selling regulations

6. Price discovery regressionDependent variable is cross-autocorrelation. A higher cross-autocorrelation implies slower price discovery.

7. Short selling and crisis • Many people argue that short selling was responsible for the market crash of 1929 • After a big fall in the markets during 1937, an uptick rule was implemented in 1938 to restrict short selling • During the dot-com bubble in late 1990s, there were substantial short sale restrictions on internet stocks • SEC banned naked short selling in 19 financial firms in July of 2008 followed by a short selling ban for 797 financial firms in September 2008.

8. Short shares as a % of shares float

9. Fails to deliver

10. Short sale ban and abnormal returns: Conditioned by dispersion of opinion

11. Conclusion Tick restrictions and restrictions on mutual funds to short sell hamper price discovery. Abnormally high short interest in financial stocks during crisis. Ban restored order but creates uncertain regulatory framework. Short selling circuit breaker represents a good solution for optimal short selling rule. Stocks with higher dispersion of opinion and a short selling ban display a higher abnormal positive return after the short sale ban relative to stocks with lower dispersion of opinion.