The Pathogen, Scapegoat, or a Miracle Drug? Short Selling and Stock Price Crash Risk

Anecdotal evidence suggests that short selling triggers financial crises or exacerbates market-wide stock price crash risk. Short sellers are often treated as scapegoats and held responsible for the occurrence of stock price crashes, especially during a period of financial market turmoil. This observation is one important reason why short selling is banned when the market is extremely volatile (see eg the 2008 US ban of short sales). In this paper, we argue that short selling does not exacerbate, but instead alleviates, the likelihood of an abrupt, large-scale decline in stock prices or simply stock price crash risk via its monitoring function. Because short sellers are typically sophisticated institutional investors, and thus have the ability to detect bad news promptly or to gain privileged access to private information, they can help expedite the price discovery process and improve the informational efficiency of stock prices. By facilitating a more timely incorporation of information (especially negative news) into stock prices, their trading activities can deter or slow down the accumulation of hidden bad news inside the firm, which in turn decreases a firm’s stock price crash risk.

Most theoretical studies predict the positive relation between short-sale constraints and stock price crash risk (see, eg, Diamond and Verrechia, 1987; Hong and Stein, 2003). However, the findings among empirical studies are mixed. Chang, Cheng, and Yu (2007) studied the Hong Kong market and find that volatility increases after short selling becomes available. Saffi and Sigurdsson (2010), using the skewness of weekly stock returns, find that relaxing short-sale constraints is not associated with an increase in either price instability or the occurrence of extreme negative returns. Beber and Pagano (2013) study the worldwide short selling ban and find that the ban is detrimental to market quality and destabilizes the market.

Endogeneity problems are difficult to examine and are the main reason why researchers cannot agree on the role that short sellers play in the stock market. A few studies attempt to resolve this issue by studying short selling regulations across countries (eg Bris, Goetzmann, and Zhu, 2007; Charoenrook and Daouk, 2005). However, they fail to settle the debate because institutions, investor protection, law enforcement, etc differ vastly across countries. In contrast to other empirical studies on the consequences of short selling, this study employs the SEC’s Regulation SHO pilot program as a natural experiment in order to examine a causal impact of short selling (ie an increase in short selling due to the temporary removal of short-sale constraints) on the stock price crash risk. To the best of our knowledge, our study is among the first to identify the causal relationship between short selling and such a negative tail risk.

Our study provides additional evidence on the economic consequences of short-sale constraints. Recent research examines the effect of RegSHO on short selling activities and market quality (Diether, Lee, and Werner, 2009), corporate financing and investment decisions (Grullon, Michenaud, and Weston, 2015), the design of CEO compensation contracts (Angelis et al, 2013), firm innovation (He and Tian, 2015), and earnings management (Fang, Huang, and Karpoff, 2015). Our study contributes to this literature by showing the monitoring role of short sellers in financial markets and studying the underlying channels through which shorting activities influence bad news hoarding and thus stock price crash risk. 

Overall, our paper provides evidence that the removal of short-sale constraints causes a firm’s stock price crash risk to decline. This effect of short selling on crash risk is stronger for firms with more severe agency problems and greater information asymmetries. This study sheds light on the monitoring role of short selling in the equity market and its impact on corporate governance. In addition, our results havepolicy implications for security market regulators.

Xiaohu Deng is Visiting Assistant Professor of Finance at Ohio University. Lei Gao is Assistant Professor of Finance at Iowa State University. Jeong-Bon Kim is Professor of Accounting and Finance at University of Waterloo.