Regulating short sales is a bad idea

In the wake of the recent stock market meltdown, the public call has increased for regulation to control some of the trading practices that seem to contribute to volatility. One of the most criticized practices is short-selling, which is borrowing shares and selling them in the hopes of buying them back later if the price declines. While short-selling provides market liquidity, critics say that it forces market prices down in times of stress.

Last week, the Securities and Exchange Commission passed a new short-sale “circuit breaker” rule that limits short sales of stocks that are falling rapidly in price. More specifically, the short sale circuit breaker prevents the execution of short-sale orders at prices that are less than or equal to the National Best Bid price in stocks whose prices have declined by 10 percent or more from the prior day’s closing price. After the circuit breaker is triggered for a given stock, it is put into place for the remainder of the day. 

Robert Battalio, finance professor at the University of Notre Dame’s Mendoza College of Business, says legislation of short sales will be costly and won’t help improve market volatility.

“Politicians and regulators tell us that this legislation will enhance public confidence in financial markets,” says Battalio. “However, they will have little if any tangible evidence to support this claim. This willingness to impose a certain, significant regulatory burden on market participants to achieve such a dubious result is at best reckless.”

The costs of this legislation, according to Battalio, include:

• Compliance cost for market participants. “They will have to make large technology investments to comply with this legislation,” he says.
• Adverse effects in using option markets to hedge risk.  “Since it has no exemption for options market makers who must short stock to hedge their sales of puts and purchases of calls from retail investors, the legislation will make it more difficult for option market makers to hedge their positions once the circuit breaker has been triggered,” says Battalio. “As a result, option market makers will increase the prices at which they sell puts and lower the prices at which they buy calls from retail investors as stock prices approach a 10 percent decline on a given day. This will adversely affect the investors who use option markets to hedge risk.”
• Less market liquidity. “The legislation will make stock and option prices less informative, since well-informed investors with value relevant information will find it harder to sell shares once the circuit breaker is triggered,” he adds. 

Battalio describes his research into regulation of short sales in the recent edition of the Center for the Study of Financial Regulation newsletter, which is available at: business.nd.edu/uploadedFiles/Academic_Centers/Study_of_Financial_Regulation/pdf_and_documents/CforFR_Newsletter_1_26.pdf

To contact Robert Battalio, call (574) 631-9428 or rbattali@nd.edu.

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