Stopped Short

Why restrictions on short selling hurt the market

When things are going really badly, blame a conspiracy. It’s been a standard move in the playbook of third-world dictators, cult leaders, and the unwashed guy on every college campus fighting the military-industrial complex. And now conspiracy theory has come to Wall Street.

As the financial sector began imploding in early September, we quickly learned that it wasn’t some toxic stew of bad luck and bad judgment that brought Wall Street to its knees. It wasn’t a bizarre perfect storm of unfortunate and unforeseeably linked events. We were told the bank failures were caused by a secret society of short sellers.

Short sellers were deliberately driving each financial stock down, in a bold and successful attempt to create a run on the bank. Thanks to the removal of the uptick rule, there was no market mechanism to stop them. And thanks to the lack of a disclosure rule, the vast short-selling conspiracy could remain cloaked behind a veil of hedge fund confidentiality, laughing anonymously in their glass and brushed aluminum offices while American capitalism burned.

After this narrative of the evil short sellers moved from the street corner to the corner office, on the morning of Friday, Sept. 19, we awoke to learn that short selling for a list of financial stocks had been completely banned. The list went way, way beyond the 19 financial stocks in a previous July emergency order, quickly metastasizing to include a huge chunk of the overall U.S. stock market. The banned list swelled to almost 1,000 stocks, including leading financial companies like CVS drugstores and Goodyear Tire & Rubber, which wisely stopped the shorts from causing a run on steel-belted radials.

Those damn ruthless shorts were themselves stopped short. So, what happened? Was the vicious cycle of fear and greed finally over? Did the sun rise that morning on a new era of upwardly mobile stock prices? Was a shortless America a stronger America? What followed was a fascinating experiment in market dynamics and market structure. Similar to George Bailey in that classic holiday movie, “It’s a Wonderful Life,” we got a rare gift: the chance to see what the markets would look like had the shorts never been born at all.

In a surprise to some, for the 14 trading days that short selling was banned, the market was not pretty. The empirical data clearly show that the ban led to higher bid/ask spreads, lower overall volume and increased trading costs for both institutional and retail investors. Furthermore, the ban was likely one of the causes of the extreme volatility in the period that followed.

The fundamental problem with restricting short selling is that there is a massive amount of money in market-neutral “long/short” hedge funds, and virtually no money in funds that are net short. The Credit Suisse/Tremont Hedge Fund Index as of August 2008 showed only 0.7 percent of hedge funds to be net short. In other words, virtually all hedge funds live up to the name. For the vast majority of funds, for every dollar they are short, they are long another dollar. Take away their ability to go short, and you have also taken away their ability to go long.

As players exited the markets, very predictably, volume dried up. According to a Credit Suisse study, volume in the banned names dropped from 28 percent of the total volume before the ban to only 16 percent of the volume by its end. Volume dried up in the non-banned names too, as many quantitative funds chose to stop trading in all stocks, afraid that shutting off an arbitrary subset of stocks would result in a portfolio very different from the one generated by their models, and therefore would be too unpredictable and risky. Total volume in all stocks decreased an estimated 25 to 40 percent from what it would have been.

With less volume trading, bid/ask spreads in the banned names almost tripled. Spreads shot up to an average of 48 basis points during the ban, up from 17 basis points prior. After the ban ended, bid/ask spreads promptly began to fall back toward normal levels, dropping back into the low 30s by the week of Oct. 20, despite that the credit crisis continued. The U.S. normally has the tightest spreads on the planet; we learned that our narrow markets are largely due to the unheralded army of quantitative long/short funds and day traders, quiet heroes who are never recognized for their selfless work.

The dramatically wider bid/ask spreads were evidence of a real decrease in liquidity. Simply put, without the long/shorts, there were fewer bids and offers in every stock. Fewer bids and offers meant that relatively small market orders were able to move stock prices all over the map, which was one of several reasons behind the marked increase in volatility. The VIX volatility index rose from 33 on the night before the ban, to a then all-time high of 57 two weeks after the shorts were sent home. The initial jump in volatility fueled by the ban then caused large losses among the many hedge funds and prop desks that make their living selling out-of-the-money puts and calls, leading to an ugly mix of margin calls and desperate liquidation that continued throughout the month of October, escalating volatility to even higher levels.

Perhaps these unpleasant side effects of the short ban would have been worth it, had the medicine worked, saving the market from plummeting and helping to nip the credit crisis in the bud. But the patient continued getting worse in spite of the aggressive therapy. The financial stocks dropped 10 out of the next 14 days, falling a whopping 22 percent during the ban, driven down entirely by long sellers. As financials continued to crash, it was revealed to the world that the evil short sellers had been a false culprit.

One of the hallmarks of conspiracy theories is that people continue to believe in them despite overwhelming evidence to the contrary. The myth that short selling is destabilizing and manipulative is so ingrained that, despite the evidence and studies, we will almost certainly see the reinstatement of some variant of the old uptick rule. A new uptick rule would be a tragedy: The previously discredited rule was killed off after a three-year pilot program and several years of academic studies revealed it to be an impediment to liquidity that offered no downside protection.

The old uptick rule and the new short-sale ban both demonstrated the common sense proposition that restricting the market from freely trading removes liquidity. Removing liquidity leads to higher bid/ask spreads and higher volatility, and is not consistent with the goal of creating fair and orderly markets.

But unfortunately for us all, it seems there’s no way to put a good conspiracy theory to bed. So get ready for some new restrictions on short selling. They will be found behind the grassy knoll, next to the UFO gathering dust in Roswell.

Dan Mathisson, a Managing Director and the head of Advanced Execution Services (AES) at Credit Suisse, is a contributing writer to Traders Magazine. The opinions expressed in this column are his own, and do not necessarily represent the opinions of the Credit Suisse Group.

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