Impact of diverse short selling restrictions on liquidity, market quality and information content of short sales

Seminar Paper, 2011

21 Pages, Grade: 1,7



1. Introduction

2. Short selling and its role in international stock markets
2.1 General definition of short selling
2.2 Influence on liquidity and market quality
2.3 Revealing private information
2.4 Political perspective during the financial crisis

3. Approved short selling restrictions by SEC in 2008
3.1 The emergency order
3.1.1 Impact on liquidity and market quality
3.1.2 Influence on information content of short sales
3.2 The short selling ban
3.2.1 Impact on liquidity and market quality
3.2.2 Influence on information content of short sales

4. The empirical analysis of Kolasinski et al. (2009)
4.1 Description of the used models
4.2 Discussion of the results

5. Conclusion

List of references

A: Formulas for liquidity and market quality
B: Formulas for information content of short sales.

1. Introduction

Since the crash of the American real estate market in 2007 and the following financial crisis, world stock markets have been criticized a lot in world press and media for being an institution of greed and egoism. The image of Wall Street bankers using the money of hard working people to maximize their own profit, selling the loans of standard households in a risky bundle of assets to other banks while ignoring risks has caused a grave decline of trust in the financial system. Tops have been the doom of Bear Stearns, which Hedge Funds collapsed under the pressure of billions of toxic subprime papers1 and the end of Lehman Brothers in September 2008. Even after the fast and unexpected rebound of world economy this trust has not been rebuild again, although financial institutions initiated different actions like reconstructing their payment models or bonus systems for employees to lay focus on a business which is not dominated by short term win maximization but long term increase of profitability.

If people talk about greedy bankers and investment banks in the last years they have started to focus on a sort of business, which became the center of political attacks during the financial crisis and was blamed as well to be the reason for increasing costs of refinancing for the so called PIIGS states (Portugal, Ireland, Iceland, Greece and Spain) in 20102. The business we talk about is the short selling business in which investors gain money if for example a stock loses value. On first sight this is confusing as the normal way of investing proclaimed since decades is to buy a cheap share of a successful company expecting an increase in the shares’ value. So why should investors gain money if this is turned upside down?

In this term paper we will examine the business of short sales, see what functions short selling has in global stock markets and what impact short selling restrictions have on different characteristics such as liquidity, market quality and information content of short sales. Therefore in section two, both the market perspective and the political perspective of short sells will be discussed. To come back to the financial crisis of 2008 in chapter three we will outline two short selling restrictions, the so called “Emergency Order” and the “Short Selling Ban” and examine their effect on liquidity, market quality and information content of short sales. This section is based on the analysis of Kolasinski et al. from 2009, who examined the points above in an empirical study and formulated different hypothesis which will be transferred out of the results we work out. In Section four we will afterwards describe and discuss the methods used in the study before we finally conclude in section five.

2. Short selling and its role on international stock markets

2.1 General definition of short selling

In international stock markets short selling plays an important role for investors as the contrarian part of “standard” investments in stocks, bonds or options. The common way of short selling is the following. An investor lends a certain number of shares of a bank or a market maker. Therefore he pays an amount, which is called borrowing fee or lending fee. The deal is arranged for a certain number of days in which the investor has to give back the shares he borrowed. The investors’ strategy is now to sell the borrowed stocks and to buy them back to a later point for a lower price than he sold them before3. The difference between the two prices is the win for the investor. He earned money due to a decreasing share price. Obviously this kind of investing is quite risky as the investor theoretically can lose more money than he originally invested. With a long4 investment, for example the investment in a company’s share, the investor risks a maximum of 100%, which he loses in case the share hits bottom and the share price falls to zero. On the other side there is no limit for the share price on the up side. In case of short selling it is the other way round. Imagine an investor borrowed a certain number of shares and sold them with the plan to buy back for a cheaper price. If the shares price develops the other way round the investor loses more money the higher the share price develops. A very popular example for what can happen to short selling investors is the Volkswagen share example. In 2008 Hedge Funds lost more than 15 billion dollars in short positions on VW shares, as those skyrocketed to the amount of 1000 euros a share5 for a day.

As we learn in Kolasinski et al. (2009, Kolasinski hereafter) the emergency order, which we will examine more detailed in section three required investors to borrow the stocks they wanted to short6. Obviously there must have been a way for investors before the emergency order was executed to short stocks even without borrowing before. This sort of short selling is known as the so called “naked” short selling7 and represents and even more risky way to short sale.

Generally short selling plays an important role for actors who try to hedge positions against risks. An example is the investment strategy of Hedge Funds. Although the priority of Hedge Funds is to maximize the return on the invested money they originally hedged the risk of losing money in so called “bear markets”, a period of time with decreasing share prices, by shorting the market8. This way the funds could compensate losses out of long investments by gains out of the short positions. This strategy is the reason those funds are still called “Hedge Funds”.

2.2 Influence on liquidity and market quality

To analyze the influence of short selling restrictions on liquidity and market quality it is first of all important to get a general understanding of how the mentioned points and short selling are related. In general a liquid market is defined as a market in which the investor can buy and sell immediately and with only a minimum loss of value. A liquid stock for example is defined by a very small bid- ask spread, the difference between the prices an investor can either buy or sell the share. The overall market quality is also influenced by how liquid the market is and as well of how fast new information are reflected in adjusted prices. This speed of adjustment is a central point in the work of Diamond and Verrecchia from 1987 and characterizes the time stock markets need to reflect all available public and private information in a shares price9. Besides in a liquid market the chance for arbitrage is relatively low. This kind of market is known as “normal market”.10 As said in 2.1 a short sale starts with selling a borrowed stock at the stock market. This kind of trading generates a lot of liquidity as the number of offered shares increases. Afterwards short sellers have to buy back the share after a certain period of time to return the shares they borrowed to the original owner. An increasing number of buys can be observed if a big short position has to be squared by an investor like a Hedge Fund. Keeping in mind the amount Hedge Funds lost with their short positions in VW in 2008 it is easy to imagine how important short selling orders are to keep the market liquid and to guarantee a good market quality.

As we learn in Diamond and Verrecchia short selling can have different reasons as the short seller is either an informed investor, who tries to take advantage out of private information or an uninformed investor, who short-sells out of liquidity reasons11. This means the second party is only short selling an asset to get liquidity for another investment or out of other reasons not connected to special information. As most investors who sort-sale, for example Hedge funds or convertible bond market makers, qualify as uninformed investors12, evidently the liquidity in the market and so market quality is highly depended on this kind of actors. The problems, which occur if those investors get banned form the market will be handled in section three. The next chapter now concentrates on the informed investors and how private information is revealed by short sales.

2.3 Revealing private information

If an investor is not selling short assets to hedge a position or because of other reason mentioned in 2.2 he must have information concerning the asset other private investors don’t have. Otherwise there would be no motivation for him to act. As those investors have a stronger background for their short selling activity it is easy to transfer the results Diamond and Verrecchia concluded in their paper, which is that for example increasing costs to short sell on the one hand reduce liquidity but on the other hand increase the information content of short sells. This is because uninformed private investors can’t compensate their losses out of short selling costs through the short sell like the informed investors can do. So the ratio of informed investors to uninformed investors will rise with increasing costs to short sell13.

The characteristic of revealing private information is one of the central aspects examined more detailed in section three, where we will find evidence for the hypotheses of Diamond and Verrecchia. The two executed short selling restrictions resulted out of the decreasing trust of investors, who in fact revealed their private information by short selling financial shares. Banks who held a big amount of toxic papers in their balance sheets were punished through the markets and only rescued out of political motivation. The political perspective of short sales played an important role during the financial crisis. That’s why we will present it more detailed in the next chapter of this section. Nevertheless it is important to point out that short selling plays a quite important role for informational efficiency of stock markets. So it’s not only a good method for uninformed investors to hedge risks or gain short term liquidity but also an important part of the general function of a market, which is to bring together all present information and to find a fair price, which reflects the information as best as possible.

2.4 Political perspective during the financial crisis

The financial crisis of 2008 and the European state crisis in 2010 gave strong evidence that the world’s financial system has weaknesses. Nevertheless economists like Adam Smith argue for a long time already that the market rules itself and should not be ruled by outsiders like politicians14. At the latest the European fund to rescue faltering states like Greece and Ireland broke with this economical axiom as markets where regulated among other things by prohibiting short sales. Although the Securities and Exchange Commission (SEC hereafter) already executed two short selling restrictions in 2008 the European crisis shows up the best how short sellers have been blamed by politicians to be the reason for decreasing value of public bonds15. To support this theory Germany for example imposed naked short selling restrictions in May 2010. As we learned in section 2.3 short selling reveals private information. So a lot of market actors argued against the political perspective that short sellers were seeking for new possibilities to maximize their own profit while ignoring what kind of threats would be coming up if a state in fact ended up in bankruptcy. Their argument was that the problems the state faced where of structural source and that this information was now priced in. From the market perspective it is the only logic reaction that a state like Greece which has no control over his financial situation has to pay an higher interest on borrowed money16 as generally a risky asset has to have an higher expected return as an riskless asset to attract investors. To conclude the market’s perspective is that short selling was and still is used as kind of a punching bag for politicians trying to cover self caused problems.

Still the European financial crisis is not over. States like Portugal17 or Spain are further candidates to use the money out of the European rescue fund18. In the next section we will now lay focus on the financial crisis of 2008 and see in detail what kind of short selling restrictions were executed by the SEC in that time.


1 See Zandi (2008), P. 167

2 See Tagesanzeiger (2010): „Wie Spekulanten von der griechischen Tragödie profitieren“ 1

3 See Lanz (1965), P.81

4 See Hull (2009), P. 181

5 See SpiegelOnline (2008): “Hedgefonds verzockten fast 15 Milliarden Euro mit VW-Aktien”

6 See Kolasinski et al. (2009), P. 1

7 See SEC (2010): “Naked Short Sales”

8 See Strachman (2009), P.4

9 See Diamond and Verrecchia (1987), P. 273

10 See Berk and DeMarzo (2008), P. 60

11 See Diamond and Verrecchia (1987), P. 293

12 See Kolasinski et al. (2009), P. 10

13 See Diamond and Verrecchia (1987), P. 279

14 See Rothengatter and Schaffer (2008), P. 13

15 See Focus Online (2010): „Merkel verspricht Spekulanten Bremse“

16 See Der Tagesspiegel (2010): „Denn das Geld misst alles“

17 See Financial Times Deutschland (2011): „Portugal will nicht unter den EU Rettungsschirm“

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Impact of diverse short selling restrictions on liquidity, market quality and information content of short sales
Karlsruhe Institute of Technology (KIT)  (FBV)
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Short selling, Leerverkäufe, Leerverkaufsbeschränkung, restrictions
Quote paper
Christian Fleischer (Author), 2011, Impact of diverse short selling restrictions on liquidity, market quality and information content of short sales, Munich, GRIN Verlag,


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