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1 The evolution of short selling regulations and trading practices Chinmay Jain Pankaj K. Jain Thomas H. McInish University of Memphis.

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Presentation on theme: "1 The evolution of short selling regulations and trading practices Chinmay Jain Pankaj K. Jain Thomas H. McInish University of Memphis."— Presentation transcript:

1 1 The evolution of short selling regulations and trading practices Chinmay Jain Pankaj K. Jain Thomas H. McInish University of Memphis

2 2 Reading Questions Define short selling. What are the pros and cons of short selling? How have the short selling regulations changed over time? Are short selling regulation changes successful in achieving the desired goal? Which aspects of short selling regulations hamper price discovery process? Describe the historical experience about regulatory action regarding short selling following crises? Characterize the changes in outstanding short interest before and after the recent financial crisis and in the periods surrounding the temporary regulatory ban on shorting. How does short selling ban affect stocks with varying levels of dispersion of opinion? Define fails to deliver in the context of short selling. Describe fails to deliver patterns during the last 5 years. Provide the details of the current short selling rules in the U.S.

3 3 Short selling Borrow and sell a stock today without actually owning it Buy back the stock in the future and return to lender Gains or losses of short seller are based on the difference between selling price and buying price No capital gain or loss to lender who continues to own the stock throughout

4 4 Advantages and disadvantages of short selling Advantages Efficient pricing in stock markets in presence of short sellers with negative information Short sellers can align the stock price with fundamental value Disadvantages Predatory short selling can push the stock price below fundamental value

5 5 History of short selling regulations DateRule Change Expected change in cross-autocorrelation Actual change in cross-autocorrelation 10/6/1931NYSE prohibited short sales on a downtick++0.0133 6/22/1936Short-short rule was introduced in the Tax Payer Act++0.0182 2/1/1938 The NYSE's tick test was tightened to require all short sales to take place on a strict uptick and was extended to all exchanges +-0.0094 8/22/1940Investment Act of 1940 restricting short selling by mutual funds+-0.0134 8/5/1997Short-short rule was repealed-+0.001 1/3/2005 Reg SHO established "locate" and "close-out" requirements for broker-dealers, in an effort to curb naked short selling +-0.0325 7/3/2007Uptick rule was removed by SEC--0.0975 7/21/2008 The emergency rule to stop naked short-selling in 19 major financial firms becomes effective. +-0.0312 8/12/2008The emergency rule expires.--0.0242 9/17/2008 After normal trading closed, the SEC initiated a ban on short selling for 797 stocks effective. SEC issued a new and temporary rule 204T, which imposes a penalty on any participant of a registered clearing agency, and any broker-dealer from which it receives trades for clearance and settlement, for having a fails to deliver position at a registered clearing agency in any equity security. SEC also eliminated the options market maker exception from Regulation SHOs close-out. ++0.0967 10/8/2008Following the 10/03/08 announcement, the short selling ban expires--0.0700 2/24/2010Effective six months later in August 2010, SEC approved alternative uptick rule designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day +TBD

6 6 Price discovery regression Dependent variable is cross-autocorrelation. A higher cross-autocorrelation implies slower price discovery. Model 1Model 2Model 3Model 4Model 5Model 6Model 7Model 8 Intercept0.0432**0.0333***0.08***0.0725***0.8634***0.5936***0.3897***0.4891*** Tick Restrictions0.0329*0.0843*** 1940 Investment Act0.0545***0.0535*** Regulation SHO-0.1194***-0.0997*** Ban on a subset of stocks (Financials)-0.1771***-0.1353*** Negative return0.0353**0.0387***0.0308**0.0411***0.0264**0.0299***0.0251**0.0316** Ln (no. of stocks)-0.1285***-0.0831***-0.0479**-0.0634*** Risk-free rate0.0113***0.0075***0.0074***0.0085*** Adjusted R Square0.07440.25290.31070.16010.38450.41270.40230.2941 No. of Observations84

7 7 Short selling and crisis Many people argue that short selling was responsible for the market crash of 1929 After a big fall in the markets during 1937, an uptick rule was implemented in 1938 to restrict short selling During the dot-com bubble in late 1990s, there were substantial short sale restrictions on internet stocks SEC banned naked short selling in 19 financial firms in July of 2008 followed by a short selling ban for 797 financial firms in September 2008.

8 8 Short shares as a % of shares float

9 9 Fails to deliver

10 10 Short sale ban and abnormal returns: Conditioned by dispersion of opinion Dispersion of Opinion Quintile Stock with short sale banStock with no short sale ban # of Firms 18-Sep19-SepSep 18-Oct 818-Sep19-SepSep 18-Oct 8 1 (Lowest)1301.86%2.38%3.79%-0.14%-0.98%-3.40% 21274.43%2.11%9.75%-0.98%0.32%-9.08% 31303.13%1.68%10.4%0.57%-0.38%-11.6% 41294.47%3.12%10.4%0.55%0.17%-7.99% 5 (Highest)1275.66%4.49%22.4%-0.10%-0.09%-19.7% p-value (Difference High minus Low) <0.00010.1934<0.00010.96820.3655<0.0001

11 Conclusion Tick restrictions and restrictions on mutual funds to short sell hamper price discovery. Abnormally high short interest in financial stocks during crisis. Ban restored order but creates uncertain regulatory framework. Short selling circuit breaker represents a good solution for optimal short selling rule. Stocks with higher dispersion of opinion and a short selling ban display a higher abnormal positive return after the short sale ban relative to stocks with lower dispersion of opinion. 11

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