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Are Short Selling Restrictions Effective?

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Are Short Selling Restrictions Effective? Are Short Selling Restrictions Effective?∗ Yashar H. Barardehi Andrew Bird Stephen A. Karolyi Thomas G. Ruchti November 30, 2018 Abstract We exploit SEC Rule 201 to study the price and trading effects of short selling restric- tions. The policy requires exchanges to implement an uptick rule until the next day's market close for stocks that cross a −10% intraday return threshold, generating rare quasi-experimental variation in short selling restrictions. On average, these restrictions increase daily returns by 30.6 bps, reduce seller-initiated volume by 4.5%, and increase off-exchange volume by 1.7%. These direct effects, which contrast with the extant literature, are concentrated in down markets, suggesting that the rule is most effective in periods of most concern to regulators. However, consistent with the substitution of potential short sales, we find significant offsetting spillover effects for peer stocks. Together, our findings yield new and timely policy implications and contribute to our understanding of short seller behavior. JEL Classification: G12, G14. Keywords: short selling, uptick rule, securities regulation, Rule 201, short-sale restrictions ∗We are grateful for comments received from Rui Albuequerque, Torben Andersen, Kelley Bergsma, Dan Bernhardt, Julio Crego, Arthur Denzau, Hans Degryse, Brent Glover, Peter Haslag, Burton Hollifield, Eric Hughson, Olivia Huseman, Tim Johnson, Nikolaos Karagiannis, Daniel Karney, Stefan Lewellen, Zhi Li, Vitaly Meursault, Nate Neligh, Lars Nord´en,Dave Porter, John Ritter, Michael Schneider, Duane Seppi, Timothy Shields, Esad Smajlbegovic (discussant), Dustin Tracy, Marc Weidenmier, Andrew Zhang, and seminar participants at Carnegie Mellon University, Chapman University, Ohio University, Oklahoma, and SAFE Market Microstructure 2018. Barardehi ([email protected]) is at the Argyros School of Business & Economics, Chapman University, and Bird ([email protected]), Karolyi ([email protected]), and Ruchti ([email protected]) are at the Tepper School of Business, Carnegie Mellon University. 1 Introduction Selling a stock short allows arbitrageurs to exploit privately-held negative information with- out owning a security. Short sellers drive price discovery, have superior public information processing skills, and make up almost one-quarter of NYSE trading volume (Hong and Stein 2003; Diether, Lee, and Werner 2009; Engelberg, Reed, and Werner 2012, 2018). Because of their information advantages, the presence of short sellers may hurt market quality. However, depending on market conditions, short sellers may also improve market quality by provid- ing liquidity.1 Determining the net impact of these opposing forces remains an empirical question. Understanding this balance would allow policy makers interested in promoting well-functioning and liquid capital markets to better evaluate the dynamic consequences of regulations that target the prevalence and intensity of short selling activity. In a world with heterogeneous beliefs, restricting short seller participation forces market prices to reflect the views of optimist investors (Miller 1977; Figlewski 1981; Hong and Stein 2007). All over the world, regulators have followed this theoretical argument to restrict short selling activity. In the wake of the 2007-2008 financial crisis alone, at least 20 major global capital markets implemented short selling bans.2 In addition to banning short sales, regu- lators have implemented short selling constraints via margin requirements, failure-to-deliver restrictions, and uptick rules. In this paper, we study the consequences of this new breed of short selling restrictions.3 1As Comerton-Forde, Jones, and Putnin.ˇs(2016) point out, short sellers both supply and take liquidity, depending on market conditions. 2See Beber and Pagano (2013). 3The literature has also investigated the connection between short selling constraints and options markets (Figlewski and Webb 1993; Grundy, Lim, and Verwijmeren 2012). 1 To do so, we exploit a rich panel of microstructure data and a threshold-based short selling restriction introduced to U.S. financial markets in 2010, Rule 201 (SEC 2010), using a regression discontinuity design. The design and implementation of the policy allows us to construct a novel methodology centered around rare quasi-random variation in short selling restrictions at the stock-hour level. We contribute a novel and timely policy evaluation as well as new inferences on the causal effects of short selling restrictions on returns, liquid- ity, and trading platform choice. We also extend our methodology to study novel general equilibrium effects of short selling restrictions, which reveal new inferences about short seller behavior and expand the scope of our policy evaluation. Our empirical approach takes advantage of the unique cross-sectional nature of Rule 201, the \alternative uptick rule." In executing Rule 201, exchanges must restrict short selling using the uptick rule once a stock's intraday returns reach a decline of 10% or greater from the previous day's close. This short selling restriction lasts until the close of the next trading day. The threshold-based design and short-lived enforcement period of the policy allow us to distinguish the effect of the uptick rule from confounding price and trading effects that would otherwise occur for on days with similarly low returns. Our methodological approach differs from previous studies of short selling restrictions (Alexander and Peterson 2008; Di- ether, Lee, and Werner 2009; Beber and Pagano 2013; Boehmer, Jones, and Zhang 2013) in that we use within stock variation in short selling restrictions, rather than solely time series or cross-sectional variation. As such, instead of the conflating effects that may be driven in general equilibrium, the variation we exploit can clearly be tied to the short selling 2 restriction policy itself.4 In many respects, we find evidence that the direct effects of Rule 201 are in line with pol- icymakers' expectations and objectives. We find that short selling restrictions substantially reduce seller initiated trading, an indication that the policy successfully restricts short selling. We also find that off-exchange trading goes up, potentially because of the frictions placed on trading by the restriction. In contrast to much of the extant literature, however, we find significant evidence that short selling restrictions increase daily returns. Compared to stocks with intraday low returns of just above −10% (i.e., unrestricted stocks), stocks with intraday low returns of below −10% (i.e., restricted stocks) have 31 basis points higher daily returns. This price effect decays within three days, but does not subsequently reverse. This suggests that the type of short selling opportunities that the policy effectively restricts are transient. Our findings on price recoveries contrast with the prior literature on short selling re- strictions. With few exceptions (e.g., Jones 2012), this literature has provided no evidence that restrictions affect stock prices as would be predicted by theories of disagreement (e.g., Miller 1977). Our contrasting evidence follows from our unique setting. Prior empirical work on short selling restrictions have studied restrictions that have been implemented either in response to a market-based stimulus or under specific market conditions, and have had long- lived enforcement periods. Rule 201 provides such granular within-stock variation that we 4We verify, in unreported results, that the SEC's price limit rules with similar circuit breakers do not drive our findings. Beginning Sept. 10, 2010, SEC and FINRA required temporary (shorter than 10-minute) trading halts following price declines of 10% or more that realize within 5-minute intervals. The universe of stocks subject to these restrictions expanded from S&P500 stocks to all National Market System stocks by June 23, 2011. The price limit restrictions are sensitive to price movements between 9:45am and 3:35pm. We verify that, if anything, our findings are significantly stronger when short-sale restrictions are triggered outside this window. Brogaard and Roshak (2016) find that price limit restrictions \reduce the frequency and severity of extreme price movements, but induce price underreaction." 3 can study the local effect of short-lived restrictions across a broad range of market conditions. Long enforcement periods may encourage short sellers to stop trading or to divert their at- tention to other markets and opportunities, and it is challenging to disentangle enforcement from the stimulus or from policymaker discretion. These limitations exist even for random- ized experiments; for example, the pilot program of Regulation SHO randomized short selling restrictions for Russell 3000 stocks during 2005 and 2006. The pilot program affected short selling activity, but had no discernible effect on prices (Diether, Lee, and Werner 2009). However, the effects of such short selling restrictions may be transient, making them diffi- cult to measure over long horizons. Furthermore, short selling restrictions may be effective only in down markets, and the program constituents experienced a 10.6% return during the period. The methodological flexibility offered by the design and implementation of Rule 201 allows us to evaluate the external validity of other policy effects in a number of dimensions. Consistent with this local average treatment effect interpretation, we find that the price effects of short selling restrictions are concentrated during down markets. This is
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