Why do short selling bans increase adverse selection? Adverse selection occurs when one party to a transaction has more precise information about the value of an asset than does the other. It is costly to the less informed trader who ends up buying or selling at an unfavourable price. Empirically, short selling bans are associated with increased levels of adverse selection in financial markets. This finding is not intuitive. When measured by their ability to predict future returns, short sellers are arguably the most informed class of traders in financial markets. Based on this, a short selling ban would be expected to decrease adverse selection by removing informed traders from the market. Specifically, such a ban would be expected to decrease adverse selection on the sell side of the market where short sellers transact.
In a recent study, I explore how a short selling ban affects adverse selection through its impact on a trader’s decision to gather costly information. Exactly opposite to expectations, the theoretical model in the paper predicts that a short selling ban will be associated with an increase in adverse selection that is concentrated on the sell side of the market. This occurs because a short selling ban decreases the benefit of becoming informed for investors who do not own the asset relative to those who do. An investor who owns the asset and is considering whether to become informed can expect to trade on their information whether it ends up being positive or negative. In contrast, an investor who doesn’t own the asset and is unable to short can only trade if their information turns out to be positive. Consequently, investors owning the asset have more incentive to become informed during a short selling ban, so information acquisition concentrates among investors owning the asset. Since a short selling ban also restricts selling to those investors who already own the asset, and a greater fraction of these investors are informed during a ban, the likelihood that a sell trade originates from an informed trader goes up—increasing adverse selection on the sell side of the market.
Empirical analysis from the 2008 short selling ban in the United States is consistent with the predictions of the model. First, I document that the effect of the ban on adverse selection is concentrated almost exclusively on the sell side of the market. This effect is economically meaningful, as increased sell side adverse selection is the dominate factor contributing to increased transaction costs during the ban, causing transaction costs for sellers to increase 50% more than for buyers.
Transaction costs are a key metric of liquidity, and the finding that the ban disproportionally harms sell side liquidity suggests caution should be taken when implementing policies which restrict short selling during down markets. Sell side liquidity during down markets is important to market stability and restricting short selling during down markets may diminish sell side liquidity when it is most needed. Also, the model’s prediction that the inability to short sell will influence the characteristics of the investors who gather information has implications that go beyond liquidity. Outside investors like short sellers help to monitor firm decisions and discipline management. If fewer outside investors choose to become informed because of an inability to trade on negative information, then the efficacy of these investors as monitors diminishes when short selling is restricted.
Dr Peter N Dixon is Financial Economist at the U.S. Securities and Exchange Commission.
*Disclaimer: The U.S. Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This post expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.