New Report Shows Bans on Short Selling Have Adverse Effects

A report in the latest edition of the Federal Reserve Bank of New York’s Current Issues in Economics and Finance, draws on recent research showing evidence against bans on short selling.  The report, written by Robert Battalio, Hamid Mehran, and Paul Schultz, found that, “evidence from the United States suggests that the bans had little impact on stock prices…the ban raised total trading costs in the U.S. equities options market by $500 million.”

In late summer and fall of 2008, when stock prices were falling around the world, the Securities and Exchange Commission imposed a ban on short selling.  The report notes that, “For the 404 financial stocks that were subject to the ban for its duration – September 18 through October 8, 2008 – the increase in (bid-ask) spreads represents an increase in liquidity costs of more than $600 million.”  They also note that throughout the entire 14 days of the short selling ban, the ban produced about $505 million in inflated liquidity costs in the options market, bringing the total cost of inflated liquidity in U.S. options and equity markets at over $1 billion.

Evidence provided in the report suggests that, “the bans did little to slow the decline in the prices of financial stocks.  In addition, the bans produced adverse side effects: Trading costs in equity and options markets increased, and stock and options prices uncoupled.”  As the researchers not, the bans seem to have the unintended consequences of raising costs and lowering liquidity.

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