Short-Selling Ban Tomfoolery in Italy, Spain

NEW YORK (TheStreet) -- You can always tell when stock market regulators have begun to panic. Beads of sweat form on their foreheads. Their hands tremble and their minds go blank. They experience memory loss. How else can you explain the decision of market regulators in Spain and Italy to reimpose a ban on short selling (reported in the Chicago Tribune) that makes no logical sense?

Studies of previous short-selling bans have proven, time and time and time again, that short-selling bans are a bad idea. They're not just ineffective but do actual harm to investors and stock issuers alike.

Spain and Italy had both banned shorting last year and lifted the bans in February. "Given extreme volatility in European stock markets that could disturb the orderly functioning of financial activity it is necessary to review stock markets' operations in order to ensure financial stability," said a statement from Spain's market regulator, CNMV.

I can almost understand why market regulators do things like this. They have to do something, after all. The markets in those two countries are tanking. The political pressure must be intense. And short sellers are not exactly the most popular of market participants at any time, least of all when markets are falling and only shorts are making money.

The unspoken logic seems to be "If people who own stock can't make money, nobody can make money." The problem with this thinking, apart from its childishness, is the fact that banning shorting is as destructive as it is psychologically satisfying. It doesn't take a great financial genius to see why that is.

First of all, shorting enhances market liquidity. It means that people who dislike stocks are not just staying out of the market, but are participating, by selling stock that they've previously borrowed (or "located," under the increasingly strict rules governing such things).

Now, admittedly there's a cadre of people who just aren't comfortable with the mechanics of shorting, ancient as they are. Selling borrowed stock can temporarily expand the float of a stock. It also means that shareholders of dividend-paying stocks in the U.S. get "substitute payments" instead of dividends when their stocks are shorted. That's annoying, because substitute payments are taxed as ordinary income as not as dividends. It's not fair, and ought to be fixed.

Otherwise shorting is a benefit for the market, and there's no better indication of that than to examine what happens when stocks stop being shorted. It's not pretty. The subject has been examined up, down and sideways by academic researchers, and the results are always the same: short-selling bans are a bad idea.

Unfortunately, in 2008 global market regulators gave academic researchers plenty of opportunity to study short-selling bans, and to determine what a rotten idea they truly are.

One particularly useful study of the panic among regulators during the financial was authored by European academics Alessandro Beber and Marco Pagano (you can find it on the Social Science Research Network Web site). They began their study by quoting two assertions by Chris Cox, head of the Securities and Exchange Commission in 2008, concerning a ban on shorting of financial stocks at the height of the financial crisis.

Cox said in September 2008 that the purpose of his emergency order was to "restore equilibrium to the markets." Only four months later, in an interview with Reuters, Cox had changed his mind. "Knowing what we know now, I believe on balance the commission would not do it again," Cox said. "The costs (of the short-selling ban on financials) appear to outweigh the benefits."

Beber and Pagano point out that regulators should have known better. They note that "theoretical reasons and previous evidence cast doubt on the benefits of short-selling bans, suggesting instead that they may reduce market liquidity and hinder price discovery, while not necessarily supporting security prices."

Indeed, the shorting ban couldn't have come at a worse time. "If short-selling bans did contribute to the decrease in stock market liquidity in 2008-09, they would have inflicted serious damage on market participants who sorely needed liquidity and could hardly obtain it on fixed income markets," their study points out.

Beber and Pagano sifted through daily data for 16,491 stocks in 30 countries, from January 2008 to June 2009. They found that "the short-selling bans imposed during the crisis are associated with a statistically and economically significant liquidity disruption," as measured by widened bid-ask spreads -- the curse of investors everywhere. The effect, they found, was particularly severe with small cap stocks.

The Beber-Pagano study is just the tip of an iceberg of harrowing data. The 2008 financial crisis short bans wreaked such havoc on the markets that they provided grist for researchers in the years that followed, and the studies showing what a bad idea they were just keep spitting out without interruption.

In another study found on the Social Science Research Network, a team of researchers at three U.S. universities found that "the ban on short-selling financial stocks imposed by the SEC in September 2008 led to substantial price inflation in the banned stocks." They estimated the "transfer of wealth" resulting from this artificial inflation of stock prices at somewhere between $2.3 billion and $4.9 billion.

Their study didn't get into this, but I would point out that bank executives -- the perpetrators of the financial crimes that practically destroyed the financial system -- were big holders of their banks' stocks, making them among the biggest beneficiaries of the short-selling ban. I'd love to see a follow-up study to show how the shorting ban enriched bank executives.

What more can I say than "Chris Cox does it again." But at least he had the good grace to admit that he goofed. The regulators in Spain and Italy are simply shameless. They know perfectly well that what they are doing is not only going to hurt market liquidity, but will artificially inflate share prices, hurting investors who are unwitting buyers of inflated stocks.

They've chosen expediency over common sense, and you can bet that they'll do it again in the next financial crisis, after this latest short-selling ban is once again proven to hurt investors.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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