Short Selling and Market Volatility

In periods of market turmoil, the negative signaling associated with restricting short selling, combined with the deterioration of liquidity and price discovery, ultimately increases uncertainty and leaves the system worse off. It is also inconsistent with the objectives of the capital markets union.

Here are a few reasons MFA members cite to explain why short selling bans make things worse:

  1. Taking liquidity away on the long side: Long/short and market neutral strategies cannot simply turn off the short leg of their trades and continue on a ‘long only’ basis. To take away the ability to adjust their short positions as they dynamically react to price movements, means taking away the ability for them to enter long positions as well – thus reducing liquidity.
  2. Taking away stabilization of short covering trades: Short positions are eventually covered by managers purchasing back stock once the price of a security has fallen. In such situations, they provide an important counterweight to the tide of selling, stabilizing prices and reducing volatility.
  3. Fueling panic around affected stocks and negative spillovers in adjacent market: Bans will affect the functioning of markets through contagion as market participants, in anticipation of further restrictions, engage in larger-than-normal reduction of positions.

Market participants engage in short selling for different reasons, including to manage risk, hedge portfolios, and reflect a view that the current market price of a security is above its fair value. Watch the video below for an overview of how short selling works and its benefits to capital markets.

If regulators in Europe nonetheless proceed with temporary bans, we would urge ESMA to include clear guidance on several important issues that have created substantial uncertainty over the last few days, three of which we would like to single out at the moment:

  1. Rolling Positions – We believe it is important to permit rolling of existing net short derivatives positions, where there is no creation of a new net short exposure, but rather maintenance of the pre-expiry position (typically this involves index futures). If firms are unable to roll existing derivatives positions it could lead to selling as firms unwind long positions that can’t be hedged effectively. As you may know, the CNMV has only today clarified, at our request, that: “Rolling of existing net short derivatives positions is allowed as the transactions covered by the ban are only those that imply the building or the increase of a net short position. Entities do not have to unwind existing positions.” The AMF has likewise today indicated that it shares this view and intends to update its FAQs to this effect. We recommend that ESMA urge NCAs to use standardized template language to clarify this for investors before the markets open.
  2. Convertible Bonds – Investors in convertible bonds often use an investment strategy in which they are long on the convertible bonds of a company and short its shares in order to hedge their risk. Importantly, these firms are not net short.  If firms were not able to hedge their risk through short sales, they would need to sell the convertible bonds. The CNMV in its guidance helpfully provided an exclusion for this type of hedging strategy, and we recommend that ESMA urge the other NCAs to provide the same exclusion. Specifically, the template language should state that: “The creation of, or increase in, net short positions when the investor who acquires a convertible bond has a delta-neutral position between the equity component of the convertible bond and the short position taken to cover that component.”

Application to Indices – The existing short selling bans provide a threshold before shorting an index is prohibited, which is important to avoid banning the shorting of an index even if it has only one banned share. The initial French ban did not specify a threshold, but has since included the following guidance: “The creation or increase of net short positions through indexed financial instruments or baskets of shares are excluded from the ban when the shares subject to the decision represent less than 50% of the composition of the index or basket.” We recommend that language become standard.

Read The White Paper

Short selling is an integral part of a carefully regulated, well-functioning market. Regulators have recognized the vital role short selling plays and acknowledged that the cost of limiting this activity appeared to outweigh the benefits. Go in-depth with research by the Managed Funds Association to understand the vital role short sales play in efficient capital markets.

MFA released a white paper that provides an in-depth look at the practice, explaining what it is and how, through appropriate regulation, it leads to healthier markets.

Learn More About Long/Short Investing Strategies