The Federal Reserve exists for a few main reasons, one of the major ones in to keep stability in the markets. This can be interpreted in a few different ways, and as such is how The Fed gains a lot of its power, or exercises a lot of power. Its no secret that when markets “go nuts” or crash many call for a ban on short selling or attempt to calm the markets in other artificial ways. Now the NY Fed has really been hitting it out of the park with some of their recent research specifically their pieces on the de-leveraging and interest on excess reserves, and now their latest on short selling. Their conclusions won’t surprise many of us who were critical of the policy at the time – in essence, banning short selling doesn’t accomplish anything:
“In September 2008, at a time of intense market stress, the United States and a number of other countries banned the short-selling of financial stocks. The bans were imposed because regulators feared that short-selling could drive the prices of those stocks to artificially low levels. Yet much remains to be understood about the effectiveness of such bans in stabilizing equity market prices.
And reexamination of this issue is particularly important in light of the latest wave of bans in Europe, including the restrictions imposed by Spain and Italy in July.
Recent research on the 2008 bans allows us to assess the costs and benefits of short-selling restrictions. The preponderance of evidence 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.
No blanket short-selling ban was in effect during August 2011, when Standard and Poor’s announced its downgrade of the U.S. bond rating. Our look at the sharp fall in U.S. equity prices following the announcement uncovers no evidence that the price decline was the result of short-selling. Indeed, stocks with large increases in short interest earned higher, not lower, returns during the first half of August 2011. Moreover, stocks that had triggered circuit-breaker restrictions and therefore could not be shorted on the day the downgrade was announced actually had lower returns than the stocks that were eligible for shorting.
Taken as a whole, our research challenges the notion that banning short sales during market downturns limits share price declines. If anything, the bans seem to have the unwanted effects of raising trading costs, lowering market liquidity, and preventing short-sellers from rooting out cases of fraud and earnings manipulation. Thus, while short-sellers may bear bad news about companies’ prospects, they do not appear to be driving price declines in markets.”
Read the full paper here.