The Use of Short-Selling Disclosure as a Policy Tool
There is often a hue and cry calling for restrictions and bans on short-selling during periods of market stress. Market participants often view short-selling during these periods as a practice that drives down stock prices to artificially low levels, thereby exacerbating market fragility. In an attempt to curb such a free-fall in stock prices, regulators often impose bans on short-selling, such as the temporary ban on short-selling financial stocks in the United States in September 2008. Research has shown, however, that bans on short-selling have little effect in curbing the fall in stock prices. Not only are such bans ineffectual, a pernicious by-product is that they can also dry up market liquidity, increase trading costs for market participants, and hamper market efficiency.
Regulators now seek to obtain desired outcomes from increased transparency of short sales by using mandatory public disclosure as a policy tool. From a regulatory standpoint, policies aimed at improving transparency of short-selling could potentially have a positive effect on these market outcomes. Short-sellers are informed investors who possess superior information about company fundamentals. Disclosure of short-sales can therefore be used as a proxy to indicate the degree of negative information about a stock. As such, greater disclosure of short-sales can benefit the wider investing public, as investors learn about the negative information underlying the disclosed short-sales more effectively. Investors trade in the same direction as the revealed negative information, and through the trading mechanism, this information is more quickly impounded into stock prices, improving market efficiency.
One potential concern about greater disclosure is that short-sellers may have to disclose their positions prematurely, before they have fully built them up to attack a mispricing. Given that short-sellers are informed investors, premature disclosure of their positions could result in other investors “free-riding” on their information without having incurred the costs of information acquisition themselves. As a result, this may reduce short-sellers’ incentives to gather information in the first place. Through this mechanism, short-selling activity could be reduced and this may in fact hamper market efficiency.
In a joint paper with Salil Pachare from the Securities and Exchange Commission (SEC) titled “Show Us Your Shorts!” we examine the role that greater disclosure of short-sales has on market efficiency. To test this, we specifically analyze trading patterns before and after SEC approved amendments to disclosure rules which came into effect on September 7, 2007. The amendments to these rules revised short interest reporting requirements, that is, the reporting of the number of shares that have been sold short but not yet covered or closed out, by member firms of all major securities exchanges and the National Association of Securities Dealers (NASD), now known as the Financial Industry Regulatory Authority (FINRA). The amendments now require member firms to increase the frequency of reporting stock-level short interest from once-per-month to twice-per-month.
Our analysis shows that more frequent disclosure of short interest helps the investing public to learn more quickly about the fundamental value of stock prices and eliminate errors in their expectations about stock prices. This mechanism contributes towards improved market efficiency. In addition, short-sellers become more willing to attack a long-term overpricing with greater public disclosure of short interest. Previously they might hesitate to attack a mispricing because of horizon risk―the risk that the mispricing can take too long to correct. With greater public disclosure of short interest, other investors learn from short-sellers readily and help incorporate their information into prices more quickly.
Our results are important for several reasons. First, gains to market efficiency can be achieved purely by increasing the frequency of reporting of aggregate stock-level short interest. Second, the policy approach of disclosing aggregate levels of short interest rather than individual traders’ short positions could potentially mitigate the concern that investors “free-ride” on specific information uncovered by the disclosure of individual short positions.
Bige Kahraman is an Associate Professor at the Saïd Business School, University of Oxford.
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