The Impact of Short Sale Restrictions

Stock lending, short selling & share prices: the UK experience

DOUGLAS SHAW, MANAGING DIRECTOR, BLACKROCK

The UK Treasury Select Committee Meeting on 27 January 2009, at which BlackRock was represented, discussed the UK banking crisis, and spent a significant amount of time on the relationship between short sales in UK banking shares and the significant decline in their share price. The Committee was justifiably concerned about the taxpayers’ ‘short put’ on UK financial stocks being exercised. The purpose of this brief article is to illustrate why we take the view that short sellers were not to blame for the banks’ share price declines.

General research into short selling
There has been extensive research into the relationship between short-selling, the stock loan that facilitates it, and changes in share prices. According to Professor Charles Jones, Chair, Finance and Economics Division, Columbia University, “virtually every piece of empirical evidence in every journal article ever published in finance concludes that without short sellers, prices are wrong.” Regulatory action in the form of the recent ban in new short sales in 34 UK-listed financial companies has given us an almost perfect case study.

The UK ban on shorting financials 19 September 2008 to 16 January 2009: a perfect case study?

Webelieve that the ban on shorting UK financials was a policy failure by many parameters. Short interest, as measured by market capitalisation on loan, was low, was falling significantly before the ban, fell further during the ban, and remained low even after the ban was lifted. For the duration of the ban, restricted UK financials performed worse than the market as a whole despite the absence of new short positions.

Clifton and Snape[1] reported that bid/offer spreads widened from 15bps to 36bps in restricted shares but only from 13bps to 20bps in unrestricted; depth worsened 59% in restricted vs 43% in unrestricted; volume fell 10% in restricted while it rose 50% in unrestricted; and turnover fell in restricted 21% but rose 42% in unrestricted stocks. Further, they noted that these outcomes were statistically significant.

Separately, the Alternative Investment Management Association commissioned Marsh and Niemer[2], who found no strong evidence that the UK restrictions changed the behaviour of stock returns in the UK or beyond. Some argue that market cap on loan does not take into account “naked” short selling (where no effort is made to borrow the stock to make delivery of the opening sale). We have not seen evidence of any material settlement failure in UK financials that would be attendant to any such naked shorting and, so, do not believe naked shorting is prevalent.

Regulatory voices
Leaving academia aside for a moment, according to the Chairman of the Financial Services Authority, Adair Turner, on 21 January 2009, “…we have no evidence at all, at the moment, that the removal of the ban on short selling has been a significant role on what has been going on [in UK financials].

“It’s very important to say that, although we did remove the ban on short selling, we have kept very strong disclosure requirements, which allow us to look day by day the very next day at transaction details on whether people have been making significant short sales. We get disclosure the moment you have a short position greater than 0.25% of a stock…we have been trawling through data to see if there is evidence of significant increases of short selling, and so far we have not seen stuff that suggested short selling, and particularly abusive short selling, is a significant role in what has occurred. So far, we are seeing no sign that short-selling or abusive short-selling is a major role. If there is, we will re-impose the ban without warning, and immediately.”

The lack of a relationship between short selling and bank share price declines is further made plain in the exchange of letters between the Treasury Committee and the Chief Executive of the FSA. We do not doubt the motivation of the regulators to find a “smoking gun” proving short sellers’ malice. If it exists, it has yet to be found.

Further, from 2005 to 2008, our own research of the FSA website has shown that only two hedge fund managers have been fined, banned, censured, or disbarred by the FSA, much less than the press coverage might have suggested. In the same period, 143 other individuals and firms have been fined.

Conclusion
It is distinctly uncomfortable to hear that short sellers have profited from the fall in bank share prices at times when the public purse has been obliged to support banks. But the discomfort can be overcome through an analysis of cause and effect. Short sellers had a legitimate expectation that bank prices would fall and, invariably, some shorted in order to meet the investment objectives set by their clients, which may include governmental pension funds.

The volume of short selling was falling before the ban, fell further during the ban, and stayed low after the ban was lifted. Short sellers did not force prices down through the weight of their sales, nor have we seen any evidence of abusive “short and distort” behaviour.

Finally, we note the absence of examples of actual abuse in the FSA’s recently published Discussion PaperDP09/1 (www.fsa.gov.uk/pubs/discussion/dp09_01.pdf).

Douglas Shaw, Managing Director, is head of BlackRock’s Proprietary Alpha Strategies team within the Account Management Group. He is a member of the Leadership Committee and has been elected as a non-Executive Director of the Alternative Investment Management Association, responsible for representing the EMEA region. His service with the firm dates back to 2006, including his years with Merrill Lynch Investment Managers, which merged with BlackRock in 2006. At MLIM, Shaw was the Head of Alternative Investments. Prior to joining MLIM in 2006, he was COO of the Children’s Investment Fund (TCI).

FURTHER READING

[1] Clifton and Snape, ‘The Effect of Short-Selling Restrictions on Liquidity, Evidence From The London Stock Exchange’, University of Sydney, 19 Dec 2008

[2] Marsh and Niemer, ‘The Impact of Short Sale Restrictions’, Cass Business School, 30 Nov 2008