The Covid-19 pandemic had not only a detrimental effect on most economies but also a considerable negative impact on financial markets. In Europe, stock prices declined between 30% and 45% from mid-February to mid-March 2020 and on March 16, the European Securities and Markets Authority (ESMA) ordered the confidential disclosure of short-selling positions above 0.1%. Subsequently, six national regulatory authorities imposed short-selling bans on March 18. In a recent paper published in Finance Research Letters, we investigate the effects of short-selling restrictions on stock market quality for the period from January 2 to June 30, 2020. For this, we compare the performance and quality measures of the six countries that enacted a ban with six countries that did not impose a ban.   

Previous research on short selling suggests that short sellers fulfil important functions as they contribute to the price discovery process by trading on negative information. Short sellers usually increase market quality and information efficiency by collecting and processing publicly available and private information, uncovering overvalued stocks and correctly predicting negative returns. However, during ‘extreme’ events, aggressive short selling may destabilize financial markets by further amplifying volatility and negative stock returns, especially for stocks of smaller firms and smaller markets. This argument usually serves to justify interventions. During the recent global financial crisis (2008-2009), the regulators decided that these potential risks should be contained by imposing short-selling restrictions. Based on the same motivation, some Eurozone countries introduced bans during the sovereign debt crisis (2011-2012). However, the empirical evidence for these crises did not support or justify these bans in hindsight. Despite these conclusions, some countries decided to implement restrictions during the Covid-19 crisis, whereas others abstained from doing so. Therefore, it is essential for regulators and policy makers to understand whether disallowing short selling had a positive or negative effect on the efficient functioning of securities markets and whether the implemented policies have achieved their stated goals. The objective of this study is to provide empirical evidence on the changes in market quality measures during the Covid-19 pandemic, which could be used as policy guidance for future crisis events.

In our research, we analyse four quantitative measures for assessing market quality: Spreads at €10k, Turnover, Price Range and Return Volatility. Liquidity often decreases in times of exceptional market uncertainty and sharply declining stock prices. We test both a price-based (Spreads at €10k) and a volume-based (Turnover) liquidity measure and find that in countries that implemented a ban, bid-ask spreads widened and turnover declined more than in no-ban countries, indicating a relatively more pronounced negative effect on market quality.

In addition, as volatility increases during crisis periods, the notion of a short-selling ban usually is to reduce price pressure in order to sustain lower volatility. We examine two measures (Price Range and Return Volatility) and observe for countries with a ban that stocks have relatively higher increases in volatility than stocks in no-ban countries. Most importantly, our novel evidence indicates relatively stronger negative effects for smaller firms and for smaller markets with short-selling restrictions.

To account for stock characteristics and other time-varying factors, we estimate fixed-effects panel regressions and also perform several robustness tests to provide supporting evidence that short-selling restrictions negatively affected market quality. Employing a matched sample and alternative market quality measures (Amihud illiquidity ratio, relative bid-ask spreads), we still find that stocks in countries with a ban experience significantly lower liquidity and higher volatility relative to stocks in no-ban countries.

During the previous global financial crisis (2008-2009) and sovereign debt crisis (2011-2012), the implemented short-selling restrictions were mainly aimed at banks to prevent bank failures and consequences of systemic risks. We analyse the effects of bank stocks separately and find that the outcomes are not much different relative to other industries. Therefore, financial stability concerns or bank runs should not have been a concern and reason for implementing a short-selling ban during the recent public health crisis. We also did not observe abnormal negative shareholder activism and market manipulation activities, which often poses an additional risk during crisis periods with excessive short selling.

In hindsight, the evidence does not justify implementing short-selling bans for market quality reasons. In contrast, it supports the decision in countries that resisted introducing such restrictions despite ample political pressure to do the opposite. Interestingly, no country imposed a ban during the more severe subsequent Covid-19 waves in fall 2020 and in 2021. However, it is important to note that the stock market reversals in all European countries in March 2020 were supported by the fiscal and monetary stimuli provided by the governments and the European Union as well as the European Central Bank, respectively. Nevertheless, the message from our research is very clear. As long as regulators can prevent illegal insider trading and market manipulation and guarantee that financial stability is maintained in both normal and crisis times, implementing short-selling restrictions will negatively affect the market quality of securities markets and consequently harm investors. Our research findings should contribute to the information set of regulators and policy makers and provide them with additional guidance in their decision-making process when considering short-selling bans once the next crisis arrives.

Wolfgang Bessler is the Deutsche Börse Senior Professor of Empirical Capital Market Research at the University of Hamburg.

Marco Vendrasco is a Researcher at the University of Hamburg and the Deutsche Börse AG in Frankfurt.