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Are Restrictions on Short Selling Good? A Look on European Markets

Are Restrictions on Short Selling Good? A Look on European Markets. Mohamed Arouri, University of Orléans, France Fredj Jawadi, Amiens School of Management, France Duc Khuong Nguyen, ISC Paris School of Management, France. Reading Questions. What’s short selling?

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Are Restrictions on Short Selling Good? A Look on European Markets

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  1. Are Restrictions on Short Selling Good? A Look on European Markets Mohamed Arouri, University of Orléans, France Fredj Jawadi, Amiens School of Management, France Duc Khuong Nguyen, ISC Paris School of Management, France

  2. Reading Questions What’s short selling? Why does short selling matter? How important is short selling in the trading volume of shares subject to short sales? How does short selling affect trends in stock prices? What are the types of short sale restrictions? What do naked short sales stand for?

  3. Reading Questions Continued Do short sale restrictions affect stock returns, volatility and trading volume? What are the CESR’s model for a permanent and harmonized regime of short selling disclosure? What are the implications of the CESR’s model for stock trading? What could be the appropriate solutions for avoiding the harmful effects of short selling?

  4. Short selling The short selling consists in arbitrage and/or speculative strategies often carried out by investors and traders using options and other derivatives. They sell assets generally borrowed from a third party with the intention of buying identical assets back at a future date A short sell position normally does not exceed ten days while a buy position has a term of one year The short seller hopes to profit from a decrease in the price of the assets between the sale and the repurchase. Setting concentration limits

  5. Matters of short selling Short sellers include a large majority of financial institutions and only some individual sellers Together, they are responsible for 25% of daily trading in the stocks subject to the short sale price tests Short selling is often viewed as a contributing factor to undesirable stock market volatility, especially in extreme market conditions

  6. Short selling and asset price • Market operators often use short selling not only to bet on a declining trend in the stock prices, but also to influence and even help determine that trend by selling large quantities of the shares of a targeted company • Short selling can force stock prices to fall below what is justifiable by the fundamentals, and destroys market and public confidence in a company which may collapse, but would have survived without the short selling activity

  7. Impacts of short sale restrictions Considering the case of ten French and German companies whose shares are concerned by short selling prohibitions, we find evidence of significant increase in volatility, general tendency of volume reduction, and insignificant change in returns Return volatility of financial stocks is not much higher after the release of the US subprime crisis in July 2007, but started to rise significantly after the French and German market authorities imposed ban on short sales

  8. The CESR’s model The initiative of the CESR is to provide a model for a Pan-European short selling disclosure regime in order to improve the transparency of net short positions, and thus market efficiency This model imposes disclosure requirements for all shares that are admitted to trading on any EEA regulated market or an EEA MTF A ratio of 0.2% net short positions would be disclosed to the relevant market regulator, while it would be disclosed, in addition to the regulator, also to the market as a whole for 0.5% net short positions

  9. Implications of the CESR’s model • Volatility increases following such measures • The disclosure requirement may also lead to a long-term loss of liquidity and decrease in trading volumes, leading potentially to a long-term fall of prices • The excess volatility resulting from the application of this restriction can increase the gap between share price and its fundamentals, and cause turbulences in stock markets. It may also have dramatic effects on the psychology of the investor reducing their confidence in the market

  10. Propositions The appropriate solution would be thus not to prohibit short sales, but to regulate them by, for example, setting trading bands in cases of extreme financial volatility and/or limiting the trading amount over a certain threshold of stock market volatility As stock markets are becoming more and more interdependent, any regulation should be global and internationally coordinated

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