By Gianfranco Siciliano

Bans in European stock markets on short-selling to counter instability caused by the COVID-19 outbreak have been ineffective. In response to a week of financial turmoil on the main European stock markets, some market regulators in Europe passed temporary short-selling bans in an attempt to stop downward speculative pressure on the equity market and help maintain investor confidence. Our research examines the effects of these restrictions on market quality during the recent pandemic.

Short-selling bans as a response to COVID-19

Short selling securities is a trading strategy whereby an investor seeks a profit or other advantages from a decline in the price of listed securities; short sellers have bearish expectations of the market. More specifically, “shorting” implies selling securities that the investor does not own, but that it borrows. After shorting an asset, the investor will eventually need to buy it back and return the shares to the lender. Investors can make a profit from short selling if they buy the shares back at a price lower than the one at which they initially sold them.

On average, in most markets, short sellers account for roughly more than 20% of trading volume and are generally regarded as traders with access to value-relevant information. However, it is well known that short selling can sometimes be coupled with illegal behaviour. To enhance the downward spiral in prices from which they hope to profit, short sellers might diffuse information, which can be misleading and incomplete, and which may constitute criminal conduct in market manipulation.

With the outbreak of the COVID-19 pandemic, we witnessed an unprecedented shock in worldwide supply and demand caused by the imposition of various lockdown measures, creating an extraordinary increase in economic uncertainty, followed by an inevitable shock to global equities.

In March 2020, stock markets were down 25% compared with January 2020, one of the most brutal and fast declines in a century. Volatility has also been extreme. In Europe, for example, the VSTOXX, which measures implied volatility of EURO STOXX 50 Index options, closed at 86% on March 16 – its second highest daily close ever. In response, regulators worldwide considered restricting or banning short selling and enhancing disclosure requirements.

Different approaches have emerged. In the United States, the Securities and Exchange Commission (SEC) did not ban short selling, as SEC chairman Jay Clayton noted that investors “need to be able to be on the short side of the market in order to facilitate ordinary market trading.”

In Europe, the response has not been uniform. In the UK, the Financial Conduct Authority confirmed on March 23, that it would not adopt a short-selling ban, and the German financial supervisor BaFin took the same position.

In France, Spain, Italy, Austria, Greece and Belgium, however, regulators announced emergency measures banning investors from engaging in short selling and transactions that might constitute or increase net short positions on stocks from March 18 to May 18.

In total, there have been three emergency bans on short selling. The regulators’ rationale was that in the pandemic context, price formation may take place in an environment of partial and sometimes misleading information, caused by rumours or inexact information.

Research findings

Some 25,855 observations of various markets affected by the ban were examined by our research and several measures to assess their effects were used. One of the key indicators is abnormal returns (measured as the difference between a firm’s actual stock return and its expected return). If an issuer or security affected by the bans on short selling outperforms the market, we might have a first, rough measure of the effect of the bans (i.e. if bans work, abnormal returns should be less “negative” than non-banned stocks during the crisis). In our study, we also considered the impact of short-selling bans on market liquidity with two additional measures, namely:

1. Bid-ask spreads; and,
2. Price impact (measured as the absolute value of the daily return-to-volume ratio)

Our findings show the bans appear to undermine the policy goals market regulators intended to promote. Across 15 European countries, banning short selling is associated with lower stock liquidity, higher information asymmetry, and lower abnormal returns as compared with non-banning short selling, thus leading to the exact outcome that these restrictions aim to prevent.

Our research further suggests financial regulators should be cautious in their decisions to introduce short-selling bans during market crises, given these bans’ lack of effectiveness and negative consequences on market quality.

We understand that short selling – which is a form of “speculation” on the negative price effects of, in this case, a health emergency, can be politically unpalatable or, at a minimum – might be characterised as tainted by unethical goals. Market supervisors might therefore be subject to a certain degree of pressure, including “political” pressure to react or to “do something.”

From this perspective, it is interesting to observe that short-selling restrictions were adopted in only some countries. It may be interesting to investigate a possible relation between the governance of supervisors and measures of independence of regulators from socio-political influences and the propensity to adopt such measures that theoretically and empirically appear of dubious utility. General economic preconditions, pre-dating the COVID-19 crisis, might have played a role in the probability of introducing short-selling bans. In the year pre-dating the pandemic outbreak, the country average 5-year credit default swaps spread (a market-based measure of insolvency risk) in countries that did not ban short selling was 104.70. This compares to 177.11 (+69.15%) in countries that did ban short selling. Therefore, it is possible that countries where financial stress was higher were more likely to impose protective measures like short-selling bans during the pandemic.

Finally, the past few months lay bare the absence of stronger coordination mechanisms amongst EU market supervisors. Our analysis does not allow a precise conclusion on the desirability of greater coordination, because it is unclear how a European regulator with direct powers might have acted.

That said, it might also be argued that flexibility could be preferable in order to adapt to specific market conditions and because it allows experimentation. The question of whether it is rational and equitable to treat issuers and investors differently in an otherwise partially harmonized system such as the EU remains unanswered, however, and it seems undeniable that these differences are not easy to justify.

This is a condensed version of an article which is due to appear in a future edition of European Company and Financial Law Review.

Dr. Gianfranco Siciliano is an Assistant Professor of Accounting at CEIBS. Read more on his research interests here.