The Effect of EU Short Selling Regulations on Liquidity and Price Efficiency

Project Start:01/2016
Researchers:Satchit Sagade, Stefan Scharnowski, Erik Theissen, Christian Westheide
Category: Financial Markets
Funded by:LOEWE

Short-selling has been a controversial topic for a long time, especially so in times of declining market prices. Subsequent to the Global Financial Crisis and during the European sovereign debt crisis, regulators in the EU put new measures into action that limited the extent, and enhanced the disclosure of, short selling. In particular, naked short-selling, i.e., short-selling without ensuring the availability of corresponding stocks to borrow, was prohibited, and a requirement to disclose short positions exceeding 0.2% of listed companies’ market capitalization has been introduced. Prior to that harmonization of regulations, individual countries had introduced constraints comparable to either or both of these rules. Previous literature has considered the effects of short selling bans on liquidity and price discovery at the height of the crisis, i.e., in a very unusual market environment. These studies further had the shortcoming that they either focused completely on the US, or they used a wide cross-section of countries whose regulatory environments and market structures differ significantly. Furthermore, single country studies had to compare financial stocks, which were hit hardest by the crisis, with stocks from other industries that had suffered less. We will study the effects both of the naked short selling prohibition and of the required disclosure of short positions of significant size, exploiting the staggered introduction of such rules by different national regulators within the EU, thus keeping the general equity market structure constant across the total sample, not relying on effects of the particularly severely hit financial stocks, and studying a period when the most extreme phase of volatility and declining prices in equity markets had passed. Furthermore, we will use data on equity lending fees from Data Explorers to study not only how the regulation affects borrowing demand, but also how stocks with different levels of shorting demand are differently affected by the new regulation. This study will provide valuable policy implications by evaluating effects of recent EU regulation.